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United States Government Accountability Office:
Understanding the Tax Reform Debate:
Background, Criteria, & Questions:
September 2005:
GAO-05-1009SP:
Contents:
Preface:
Introduction:
Section 1: Revenue--Taxes Exist to Fund Government:
The Current Tax System:
Historical Trends in Tax Revenue:
Historical Trends in Federal Spending:
Borrowing versus Taxing as a Source of Resources:
Long-term Fiscal Challenge:
Revenue Effects of Federal Tax Policy Changes:
General Options Suggested for Fundamental Tax Reform:
Key Questions:
Section 2: Criteria for a Good Tax System:
Equity:
Equity Principles:
Measuring Who Pays: Distributional Analysis:
Key Questions:
Economic Efficiency:
Taxes and Economic Decision Making:
Measuring Economic Efficiency:
Taxing Work and Savings Decisions:
Realizing Efficiency Gains:
Key Questions:
Simplicity, Transparency, and Administrability:
Simplicity:
Transparency:
Administrability:
Trade-offs between Equity, Economic Efficiency, and Simplicity,
Transparency, and Administrability:
Key Questions:
Section 3: Transitioning to a Different Tax System:
Deciding if Transition Relief Is Necessary:
Identifying Affected Parties:
Revenue Effects of Transition Relief:
Policy Tools for Implementing Transition Rules:
Key Questions:
Appendixes:
Appendix I: Key Questions:
Section I: Revenue Needs--Taxes Exist to Fund Government:
Section II: Criteria for a Good Tax System:
Equity:
Efficiency:
Simplicity, Transparency, and Administrability:
Section III: Transitioning to a Different Tax System:
Appendix II: Selected Bibliography and Related Reports:
Government Accountability Office:
Congressional Budget Office:
Other Selected Sources:
Appendix III: Glossary:
Tables:
Table 1: Features of the Current Tax System:
Table 2: The 10 Largest Tax Expenditures in 2004, Outlay Equivalent
Estimates:
Table 3: Measures of Tax Burden, Distribution of Total Federal Taxes
and Individual Income Taxes in 2004:
Table 4: The Corporate Tax Rate Schedule: Simple but Not Transparent:
Figures:
Figure 1: Issues to Consider When Assessing Alternative Tax Proposals:
Figure 2: Revenue Overview:
Figure 3: Sum of Tax Expenditure Outlay-Equivalent Estimates Compared
to Discretionary Spending, 1981-2004:
Figure 4: Federal Revenue as a Percentage of GDP and by Source, 1962-
2004:
Figure 5: Federal Spending as a Percentage of GDP and by Spending
Category, 1962-2004:
Figure 6: Federal Tax Revenue versus Federal Spending, 1962-2004:
Figure 7: Composition of Federal Spending as a Share of GDP, Assuming
Discretionary Spending Grows with GDP after 2004 and That Expiring Tax
Provisions Are Extended:
Figure 8: Formula for Determining Tax Revenue:
Figure 9: Trade-offs in the Criteria for Assessing Tax Reform:
Figure 10: Equity Overview:
Figure 11: Efficiency Costs Are One Cost Taxpayers Face in Complying
with the Tax System:
Figure 12: Efficiency Overview:
Figure 13: Simplicity, Transparency, and Administrability Overview:
Figure 14: Compliance Burden Is One Cost Taxpayers Face in Complying
with the Tax System:
Figure 15: Taxpayer Noncompliance Categorized by Amount of Withholding
and Information Reporting, 1992:
Figure 16: Transition Issues Overview:
[End of section]
Preface:
Taxes are necessary because they fund the services provided by
government. In 2005, Americans will pay about $2.1 trillion in combined
federal taxes, including income, payroll, and excise taxes, or about
16.8 percent of gross domestic product.
Beyond funding government, the federal tax system has profound effects
on the economy as a whole and on individual taxpayers, both for today
and tomorrow. Taxes change people's behavior and influence the economy
by altering incentives to work, consume, save, and invest. This, in
turn, affects economic growth and future income--and thus future
government revenues. At the same time, the current tax system generates
fierce controversy over fairness--who should pay and how much they
should pay. In addition, the current tax system is widely viewed as
overly complex, thereby reducing the ability of individuals to
understand and comply with the tax laws. Furthermore, the tax system is
costly to administer with most of the costs of administration, such as
record keeping, understanding the laws, and preparing returns, borne by
taxpayers.
Concerns about the economic effectiveness, fairness, and growing
complexity of the current tax system raise questions about its
credibility. These concerns have led to a growing debate about the
fundamental design of the federal tax system. The debate includes the
type of base--income or consumption--and the rate structure--flatter or
more progressive. Additionally, some question to what extent and how
the tax system should be used to influence economic behavior and social
policy.
Some see tax rates as too high--discouraging work, savings, and
investment and consequently slowing economic growth. At the same time,
the myriad of tax deductions, credits, special rates, and so forth
cause taxpayers to doubt the fairness of the tax system because they do
not know whether those with the same ability to pay actually pay the
same amount of tax. In addition, tax expenditures, also called tax
preferences, just like spending programs, can lead to higher tax rates
over time. Complexity and the lack of transparency that it can create
exacerbate doubts about the current tax system's fairness. Public
confidence in the nation's tax laws and tax administration is critical
because we rely heavily on a system of voluntary compliance. If
taxpayers do not believe that the tax system is credible, is easy to
understand, and treats everyone fairly, then voluntary compliance is
likely to decline.
The debate about the fundamental design of the tax system is occurring
at a time when the nation also faces large current deficits and a
significant and structural long-term fiscal imbalance. Long-term budget
simulations by GAO, the Congressional Budget Office, the Office of
Management and Budget, and nongovernment analysts show that absent
policy changes, the federal budget is on an unsustainable path. Known
demographic trends and rising health care costs will cause ultimately
unsustainable deficits and debt that will threaten our national
security as well as the standard of living for the American people in
the future.
While additional economic growth is critical and can help to ease the
burden, the projected fiscal gap is so great that it is unrealistic to
expect that growth alone will solve the problem. Ultimately, the nation
will have to decide what it wants from the federal government, that is,
what level of spending do we want on programs, tax preferences, and
other government services and how we will pay for that spending.
Clearly, tough choices will be required. Addressing the projected
fiscal gap will prompt policymakers to examine the advisability, which
includes both the effectiveness and affordability, of a broad range of
existing programs and policies throughout the entire federal budget--
spanning discretionary spending, mandatory spending, entitlement
programs, tax expenditures tax rates, and tax system design. This
examination will likely result in actions affecting both tax revenues
and tax expenditures.
The background, criteria, and questions presented in this report are
designed to aid policymakers and the public in thinking about how to
develop tax policy for the 21ST century. This report, while not
intended to break new conceptual ground, brings together a number of
topics that tax experts have identified as those that should be
considered when evaluating tax policy. This report attempts to provide
information about these topics in a clear, concise, and easily
understandable manner for a nontechnical audience. In developing this
report, we relied on government studies, academic articles, and the
advice of tax experts to provide us with information on the issues
surrounding the tax reform debate. For a short bibliography of related
publications, see appendix II. For easy reference, key terms are
defined in the glossary located in appendix III--these glossary terms
appear in bold type the first time they are used in the text.
This publication was prepared under the direction of James R. White,
Director, Strategic Issues (Tax Policy and Administration Issues), who
may be reached at (202) 512-9110 or [Hyperlink, WhiteJ@gao.gov].
Contact points for our Offices of Congressional Relations and Public
Affairs may be found on the last page of this report. Kevin Daly,
Tom Gilbert, Don Marples, Donna Miller, Ed Nannenhorn, and Amy
Rosewarne made key contributions. This report will be available at no
charge on the GAO Web site at [Hyperlink, http://www.gao.gov].
Signed by:
David M. Walker:
Comptroller General of the United States:
[End of section]
Introduction:
This report provides background information, criteria, and key
questions for assessing the pros and cons of tax reform proposals, both
proposals for a major overhaul of the current federal tax system and
incremental changes to the system. Figure 1 outlines the key issues
that we address. First, we discuss how the size and role of the federal
government drive the government's revenue needs. Second, we describe a
set of widely accepted criteria for assessing alternative tax
proposals. These criteria include the equity, or fairness, of the tax
system; the economic efficiency, or neutrality, of the system; and the
simplicity, transparency, and administrability of the system. The
weight one places on each of these criteria is a value judgment and
will vary among individuals. As we note, there are trade-offs to
consider among these criteria, and we discuss how these criteria can
sometimes be in conflict with each other. Finally, we turn to a
consideration of the issues involved in transitioning from the current
tax system to an alternative tax system.
Figure 1: Issues to Consider When Assessing Alternative Tax Proposals:
[See PDF for image]
[End of figure]
The primary purpose of the tax system is to collect the revenue needed
to fund the operations of the federal government, including its
promises and commitments. Tax revenues may not fully match government
spending each year, but over time, the federal government needs to be
able to raise sufficient revenue to cover its current and expected
financial obligations. Decisions about spending and the role of
government have a direct impact on the government's ultimate revenue
needs.
Whether the resources to fund government spending are provided through
taxes or borrowing has consequences for the economy and the federal
budget. Borrowing (which has often led to budget deficits) may be
appropriate for federal investment such as building roads and
scientific research, and during times of recession, war, and other
temporary challenges. However, federal borrowing also absorbs scarce
savings that would otherwise be available for growth-enhancing private
investment. In addition, large amounts of borrowing may increase the
share of interest payments in the federal budget overtime, placing
additional pressure on future budgets.
One's view about the equity of a tax system is based on subjective
judgments about the fairness of the distribution of tax burdens. The
actual burden of a tax--the reduction in economic well-being caused by
the tax--is not always borne by the people who pay the tax to the
government because tax burdens can be shifted to other parties. For
example, the burden of a tax on business can sometimes be shifted to
consumers by increasing prices or to workers by decreasing wages.
Public debates regarding the equity of the tax system reflect a range
of opinions about who should pay taxes and how much of the tax burden
should be shouldered by different types of taxpayers.
Taxes impose efficiency costs by altering taxpayers' behavior, inducing
them to shift resources from higher valued uses to lower valued uses in
an effort to reduce tax liability. This change in behavior can cause a
reduction in taxpayers' well-being that, for example, may include lost
production (or income) and consumption opportunities. Efficiency costs,
along with the tax liability paid to the government and the costs of
complying with tax laws, are part of the total cost of taxes to
taxpayers. One of the goals of tax policy, but not the only goal, is to
minimize compliance and efficiency costs. The extent to which
efficiency costs can be reduced by reforming the tax system depends on
the design features of the new tax system, such as the nature and
number of any tax preferences.
Simplicity, transparency, and administrability are related but
different characteristics of a tax system. Simplicity is a gauge of the
time and other resources taxpayers spend to comply with the tax laws.
This includes the time and resources spent on record keeping, learning
about tax obligations, and preparing tax returns. The transparency of a
tax system refers to taxpayers' ability to understand how their
liabilities are calculated, the logic behind the tax laws, what their
own tax burden and that of others is, and the likelihood of facing
penalties for noncompliance. Administrability refers to the costs,
ultimately borne by taxpayers, of collecting and processing tax
payments as well as to the costs of enforcing the tax laws. While
simplicity, transparency, and administrability are related concepts,
they are not the same thing. A very simple tax rule may not be
transparent if the rationale for the rule is not clear. Similarly, not
all simple taxes are easy to administer.
Designing tax policy requires making trade-offs among these criteria.
For example, a proposal to improve the efficiency and simplicity of the
tax code may involve eliminating exemptions or deductions originally
introduced to improve the equity of the system. Moreover, some criteria
include subjective elements. One individual's perception of the equity
of a tax proposal can differ from another's. However, being subjective
or objective does not make a criterion superior.
In addition to determining the type of tax system, policymakers also
determine the amount of revenue to be raised, which involves balancing
the costs of taxes against the benefits of government services. Despite
the fact that no tax system is perfectly fair, efficient, simple,
transparent, and without administrative costs, in general people are
willing to pay taxes and bear the other costs of the tax system because
they desire the benefits of government and understand that sufficient
tax resources are necessary for a sound fiscal policy in the long term.
Finally, because moving to an alternative tax system creates winners
and losers, transition rules may be included in tax reform proposals to
mitigate some of the windfall gains and windfall losses that are likely
to occur. However, debate exists as to whether transition rules, which
are usually proposed on equity grounds, are appropriate because they
may also reduce the efficiency of the tax system and temporarily make
the tax system more complex.
Tax reform proposals can range from small changes to the tax code to
more comprehensive changes. The issues and questions we discuss in this
report are designed to apply to both incremental changes to the tax
system, such as changing tax expenditures to encourage savings, and to
more comprehensive tax reform proposals, such as switching from a
predominantly income-based tax to a consumption tax base.
In addition to discussing the criteria used to evaluate changes to the
tax system, this report provides information about economic and
budgetary trends, the current tax system, and definitions of important
tax concepts. For each section of the report, we provide a set of key
questions designed to help identify the important features of the
proposals This is information that we believe would be useful for
evaluating the proposals and identifying limitations of the data and
analysis.
[End of section]
Section 1: Revenue--Taxes Exist to Fund Government:
Taxes exist to fund the services provided and the promises made by the
government. Since tax revenue may not match spending in each year, the
resources needed to fund government can be also be raised by borrowing
(deficit financing). Both taxes and borrowing affect economic
performance. Taxes can affect the economy because they alter decision
making by people and businesses. Federal borrowing absorbs savings
otherwise available for private investment and postpones the need to
tax or reduce spending. (See fig. 2.)
Figure 2: Revenue Overview:
[See PDF for image]
[End of figure]
The Current Tax System:
The federal tax system in the United States primarily consists of five
types of taxes: (1) personal income taxes; (2) social insurance taxes
(employee and employer contributions for Social Security, Medicare, and
unemployment compensation); (3) corporate income taxes; (4) estate and
gift taxes; and (5) excise taxes based on the value of goods and
services sold and other taxes. The tax bases, rates, and collection
points of the major federal taxes are summarized in table 1.
Table 1: Features of the Current Tax System:
Type of tax: Personal income taxes (PIT);
Tax base: Regular PIT: Personal income, including income from wages,
interest and dividends, capital gains, and small business income;
Numerous tax expenditures exist that reduce the size of the tax base;
Personal alternative minimum tax (AMT): Taxable income exceeding
certain threshold amounts based on filing status;
Tax rates: Regular PIT: Graduated rate structure: Statutory marginal
rates of 10%, 15%, 25%, 28%, 33%, and 35%. Deductions and other tax
expenditures, such as refundable tax credits like the Earned Income Tax
Credit, create a group of taxpayers who have no tax liability or a
negative tax liability; Personal AMT: 26% or 28% depending on taxable
income subject to the AMT. Individuals are eligible for a credit for a
portion of the AMT paid in a prior year;
Collection points: Regular PIT: Employers withhold payments, but
individuals file tax returns wherein they are also required to disclose
nonwage income and remit appropriate taxes. Small business owners self-
report income and remit taxes to the government. Personal AMT:
Individuals compare their regular PIT liability to their AMT liability
and pay the greater of the two (less taxes previously withheld or paid
during the year).
Type of tax: Corporate income taxes (CIT);
Tax base: Regular CIT: Corporate profits (total revenues less total
expenses). Numerous tax expenditures exist that reduce the size of the
tax base; Corporate AMT: Broader definition of the tax base (corporate
income) than regular CIT; less generous accounting rules;
Tax rates: Regular CIT: Statutory marginal rates range from 15% to 35%;
Corporate AMT: 20% for all corporate income subject to the tax less the
AMT credit for that tax year;
Collection points: Regular CIT: Corporations file tax returns and remit
payment to the government. Corporate AMT: Corporations compare regular
CIT to corporate AMT liability and pay the greater of the two.
Type of tax: Social insurance taxes;
Tax base: Social security: First $90,000 of employee wages; Medicare:
All wages;
Tax rates: 6.2% employee contribution; 6.2% employer contribution;
12.4% for self-employed; Medicare: 1.45% employee contribution; 1.45%
employer contribution; 2.90% for self-employed;
Collection points: Social security: Employers withhold taxes from
employee paychecks; The self-employed remit taxes themselves. Medicare:
Employers withhold taxes from employee paychecks; The self-employed
remit taxes themselves.
Type of tax: Unified transfer tax--estate, gift, and generation
skipping tax (GST);
Tax base: Estate tax: Fair market value of the decedent's cash and
securities, real estate, trusts, annuities, business interests, and
other assets included in the decedent's estate at death less allowable
deductions in excess of $1.5 million in 2005. There is an unlimited
deduction for transfers to a surviving spouse; Gift tax: Tax is imposed
on the value of lifetime taxable transfers of gifts of property.
Applicable exclusion amount of $1 million for 2005. In addition, there
is an annual exclusion of $11,000 per donee and an unlimited exclusion
for tuition and medical payments; GST: Total generation skipping
transfers (such as from a grandparent to a grandchild) in excess of
$1.5 million in 2005;
Tax rates: Estate tax: Rates range from 45% to 47% in 2005. As a result
of recent tax legislation, estate tax rates will fluctuate before the
estate tax is eliminated in 2010. However, the estate tax will be
reinstated in 2011; Gift tax: Rates range from 41% to 47% in 2005.
Rates fluctuate in the same manner as for the estate tax in coming
years. Gift tax will be retained following repeal of estate and GST;
GST: 47% (or highest statutory marginal tax rate for the estate tax) in
2005. GST rates decrease until the tax is repealed in 2010. GST is
reinstated in 2011;
Collection points: Estate tax: Decedent's estate is responsible for
filing returns and remitting payment to the government. Gift tax: Gift
donor is responsible for filing returns and remitting payment to the
government. GST: Depending on the form of the generation skipping
transfer, gift donor, donee trustee, or decedent's estate is
responsible for filing returns and remitting payment to the government.
Type of tax: Excise and other taxes;
Tax base: Estate tax: Selected goods, services, and other items (i.e.,
gasoline, alcoholic beverages, tobacco, airline tickets, etc.);
Tax rates: Various rates apply to different goods, services, and other
items;
Collection points: Generally collected by businesses, which remit
payments to the government on a quarterly basis.
Source: GAO analysis of Internal Revenue Service information.
[End of table]
The revenue raised by the major federal taxes is determined by the size
of their bases, their rates, and their levels of compliance. In
addition, each tax base is affected by the size and growth rate of the
economy.
Although called income taxes, the current federal individual and
corporate income taxes have some features characteristic of a
consumption tax. The current income tax system taxes the income of
individuals and corporations, such as wages, interest, dividend income,
capital gains, and other types of business income, including that of
sole proprietorships and partnerships. (Some income is double taxed--
corporate earnings are subject to the corporate income tax and are
taxed again under the individual income tax when they are distributed
as dividends or as realized capital gains when shareholders sell their
stock.) However, some income is treated as it would be under a
consumption tax where income that is saved or invested is exempted from
tax until it is consumed. For example, up to certain limits, income
that is contributed to individual retirement accounts and defined
contribution pension plans is tax-deferred during accumulation. The
result is a hybrid income-consumption tax base wherein some types of
savings and investment are exempt from taxation, but other types are
not.
The current tax system includes tax expenditures, also called tax
preferences, which reduce the size of the tax base. Tax expenditures
are usually justified on the grounds that they promote certain social
or economic goals. They grant special tax relief (through deductions,
credits, exemptions, etc.) that encourages certain types of behavior by
taxpayers or aids taxpayers in certain circumstances. Tax expenditures
can promote a wide range of goals. For example, individual retirement
accounts, discussed above, promote the goal of increased personal
savings and investment, and the tax expenditures for owner-occupied
homes encourage homeownership.
Summing one measure of tax expenditures, called outlay-equivalents,
indicates that the aggregate value of tax expenditures was about $850
billion in fiscal year 2004. Outlay-equivalents are budget outlays that
would be required to provide the taxpayers who receive the tax
expenditures with the same after-tax income as would be received
through the tax expenditures.[Footnote 1] As an indication of the size
and impact of tax expenditures, figure 3 compares them to discretionary
spending. In some years the outlay-equivalents for income tax
expenditures exceeded federal discretionary spending.
Figure 3: Sum of Tax Expenditure Outlay-Equivalent Estimates Compared
to Discretionary Spending, 1981-2004:
[See PDF for image]
[End of figure]
A few large income tax expenditures account for most of the aggregate
value. The 10 tax expenditures listed in table 2 accounted for over 60
percent of the outlay-equivalents in fiscal year 2004. The estimates in
the table are for income tax expenditures. They do not include
provisions that exclude income from other taxes, such as payroll taxes.
For example, the income tax exclusion for health care permits the value
of health insurance premiums to be excluded from employees' taxable
earnings and also excludes this value from the calculation of Social
Security and Medicare payroll taxes for both employees and employers.
Table 2: The 10 Largest Tax Expenditures in 2004, Outlay Equivalent
Estimates:
Dollars in billions.
Tax preference: Exclusion of employer contributions to medical
insurance premiums and medical care;
Outlay equivalents: $126.7.
Tax preference: Deductibility of mortgage interest on owner-occupied
homes;
Outlay equivalents: $61.5.
Tax preference: Net exclusion of pension contributions and earnings:
401(k);
Outlay equivalents: $58.2.
Tax preference: Net exclusion of pension contributions and earnings:
employer plans;
Outlay equivalents: $57.3.
Tax preference: Deductibility of nonbusiness state and local taxes
(other than on owner-occupied homes);
Outlay equivalents: $45.3.
Tax preference: Accelerated depreciation of machinery and equipment;
Outlay equivalents: $44.7.
Tax preference: Exclusion of interest on public purpose state and local
debt;
Outlay equivalents: $37.5.
Tax preference: Capital gains (other than agriculture, timber, iron
ore, and coal);
Outlay equivalents: $35.9.
Tax preference: Capital gains exclusion on home sales;
Outlay equivalents: $35.0.
Tax preference: Exclusion of net imputed rental income on owner-
occupied homes;
Outlay equivalents: $32.8.
Source: GAO analysis of Office of Management and Budget (OMB), Budget
of the United States Government, Fiscal Year 2006, Analytical
Perspectives.
[End of table]
In the current tax system, tax rates vary across types of tax.
Individual income and corporate income above certain levels are
generally taxed at graduated rates. Taxes on individual income have six
statutory marginal tax rates (the rate of tax paid on the next dollar
of income that a taxpayer earns), ranging from 10 percent to 35
percent. Income earned by corporations has a statutory marginal rate
structure that ranges from 15 percent to 35 percent. A separate rate
structure exists for the individual Alternative Minimum Tax (AMT)--a
tax on individual income that was originally designed to keep taxpayers
with higher incomes from taking advantage of various tax provisions in
order to pay little or no income tax. The current tax system also
includes social insurance taxes, which are applied to wages at flat
rates and remitted in equal shares by employees and employers. However,
currently the first $90,000 of an individual's wages is subject to
payroll taxes for Social Security, while all wages are subject to
payroll taxes for Medicare.
The government's administrative burden and taxpayers' compliance burden
vary depending on the type of taxpayer, the type of tax, and the
collection point of the tax. For the individual income tax and social
insurance taxes, the primary collection point occurs at the business
level: employers bear the burden of withholding employees' taxes from
their wages and remitting the tax payments to the government. However,
all individuals with income above certain thresholds based on personal
allowances and a standard deduction still must file tax returns. The
Internal Revenue Service (IRS) bears the administrative burden of
monitoring taxpayer compliance and applying penalties to noncompliant
taxpayers when necessary.
Historical Trends in Tax Revenue:
Total federal tax revenues have fluctuated from roughly 16 to 21
percent of gross domestic product (GDP) over the last 43 years. In
figure 4, total federal revenue is highest in 2000 at 20.9 percent of
GDP and lowest in 2004 at 16.3 percent of GDP.
As figure 4 also illustrates, there have been important changes to the
composition of federal revenues over the last 43 years. Corporate and
excise tax receipts as a percentage of GDP have declined since 1960,
while social insurance tax receipts have grown. The individual income
tax and social insurance taxes have accounted for the majority of
federal revenues during this period.
Figure 4: Federal Revenue as a Percentage of GDP and by Source, 1962-
2004:
[See PDF for image]
[End of figure]
Historical Trends in Federal Spending:
As figure 5 illustrates, over the last 43 years, federal spending as a
portion of GDP has ranged from a low of 17.2 percent of GDP in 1965 to
a high of 23.5 percent of GDP in 1983. In addition, figure 5
illustrates that as is the case with revenues, important changes to the
composition of federal spending have occurred. For example, since 1962,
the total share of federal spending devoted to national defense has
decreased relative to the share devoted to Social Security and health
care. Government provision of Social Security and health care accounted
for over 40 percent of government spending in 2004, a dramatic increase
from the share before 1965 when the Medicare and Medicaid programs were
enacted.
Figure 5: Federal Spending as a Percentage of GDP and by Spending
Category, 1962-2004:
[See PDF for image]
[End of figure]
Borrowing versus Taxing as a Source of Resources:
The resources to fund government are raised primarily through taxes.
However, borrowing is another source. Figure 6 combines figures 4 and 5
to show that the federal government has generally run a deficit in
recent decades.
Figure 6: Federal Tax Revenue versus Federal Spending, 1962-2004:
[See PDF for image]
[End of figure]
Public sector resources, whether from taxes or borrowing, make the
benefits of government possible. However, taxes and borrowing also have
costs. Obviously, they transfer money from the pockets of the public to
the government. But they also affect the performance of the economy. As
will be discussed under the criteria for a good tax system, taxes
affect the performance of the economy by altering decisions, such as
how much to work and save, what to consume, and where to invest.
Federal borrowing has advantages and disadvantages that vary depending
on economic circumstances. Borrowing, in lieu of higher taxes or lower
government spending, may be viewed as appropriate during times of
economic recession, war, or other temporary challenges. Federal
borrowing might also be viewed as appropriate for federal investment,
such as building roads, training workers, and conducting scientific
research, that contributes to the nation's capital stock and
productivity. If well chosen, such activities could ultimately help
produce a larger economy. However, if not well chosen, such spending
could displace more productive private sector investments.
Federal borrowing also can impose significant costs and risks.
Borrowing for additional spending or lower taxes for current
consumption improves short-term well-being for today's workers and
taxpayers, but does not enhance our ability to repay the borrowing in
the future. In the near term, federal borrowing also absorbs scarce
savings available for private investment and can exert upward pressure
on interest rates. Over the long term, federal borrowing that restrains
economic growth will also restrain the standard of living of future
workers and taxpayers.
Long-term Fiscal Challenge:
As discussed in our report on challenges facing the government, the
fiscal policies in place today--absent substantive entitlement reform
and changes in tax and spending policies--will result in large,
escalating, and persistent deficits that are economically unsustainable
over the long term.[Footnote 2] In other words, given current forecasts
for growth, government spending and resources, today's policies cannot
continue and must change.
Over the next few decades, as the baby boom generation retires, federal
spending on retirement and health programs, such as Social Security,
Medicare, and Medicaid, will grow dramatically and bind the nation's
fiscal future. Absent policy changes on the spending and/or revenue
sides of the budget, a growing imbalance between federal spending and
tax revenues will mean escalating and ultimately unsustainable federal
deficits and debt. For example, as figure 7 indicates, if discretionary
spending grows at the same rate as the economy and all expiring tax
provisions are extended, federal revenues could be adequate to cover
little more than interest on the federal debt by 2040.
Figure 7: Composition of Federal Spending as a Share of GDP, Assuming
Discretionary Spending Grows with GDP after 2004 and That Expiring Tax
Provisions Are Extended:
[See PDF for image]
Notes: This figure is based on the assumption that discretionary
spending grows at the same rate as GDP after 2004 and that expiring tax
provisions are extended. Despite our assumption that expiring tax
provisions are extended, revenue as a share of GDP increases through
2015 due to (1) real bracket creep, (2) more taxpayers being subject to
the AMT, and (3) increased revenue from tax-deferred retirement
accounts. After 2015, revenue as a share of GDP is held constant.
[End of figure]
Regardless of the assumptions used, reasonable long-term simulations
indicate that the problem is too big to be solved by economic growth
alone or by making modest changes to existing spending and tax
policies. While entitlement reform as well as mandatory and
discretionary spending cuts will likely be needed to close the long-
term financial gap, the structure of the tax system should also be part
of the debate as policymakers grapple with the nation's long-term
fiscal challenge. As part of this process, consideration could be given
to improving taxpayer compliance and enforcement efforts, expanding the
tax base, increasing current tax rates and tax rates on future
generations, or a combination of these.
Revenue Effects of Federal Tax Policy Changes:
The amount of revenue raised from a tax is determined by the tax base,
the tax rate, and the compliance rate, as shown in figure 8. Changes to
the tax code can be revenue neutral, meaning that they are designed to
raise the same amount of revenue as the current tax laws, or tax code
changes can be designed to raise more or less revenue than the current
tax laws. Additionally, changes to the federal tax system can have
significant implications for state and local government tax revenues.
Figure 8: Formula for Determining Tax Revenue:
[See PDF for image]
[End of figure]
Tax revenue can be affected by changing the current tax base, which
could include replacing it with a pure consumption tax base or
broadening the current tax base by eliminating certain tax
expenditures. As we noted earlier, tax expenditures, which the
government uses to encourage specific social and economic goals, reduce
the size of the tax base. Tax expenditures may be justified because, in
some cases, it may be less costly to achieve these goals through
reductions to the tax base than through spending programs. The choice
of whether to use tax expenditures or spending depends on which
approach better targets and meets the program's objectives at the
lowest cost. Even though spending programs show up in the federal
budget and tax expenditures are not included as federal spending,
taxpayers are paying for the program in either case. Both should be
transparent and subject to periodic oversight concerning such factors
as whether they meet the program's objectives or conflict with other
government programs, grants, and regulations that have similar
objectives. The tax expenditure for employer-provided health care,
discussed in text box 1, illustrates the importance of such oversight.
Text Box 1: Tax Expenditure for Employer Medical Insurance Premiums and
Medical Care; The current U.S. tax system excludes employer-provided
health insurance from individuals' taxable income even though such
insurance is a form of income (noncash compensation). As table 2
showed, the Treasury Department estimates that the tax subsidy for
employer-provided health insurance was over $126 billion in outlay-
equivalents during 2004, not including forgone social insurance taxes
and state taxes; The tax exclusion increases the proportion of the
population covered by health insurance. Currently, nearly 45 million
Americans are without health insurance. The tax exclusion encourages
employers to offer and employees to participate in health insurance
plans, increasing the proportion of workers covered. The exclusion
addresses a well-known problem with health insurance. Because
individuals may be better able to anticipate their health care needs
than insurers, health care plans may attract customers with higher risk
of poor health, resulting in higher premiums. By encouraging the
pooling of high-and low-risk individuals, the tax exclusion may help to
reduce premiums below those that individuals would face if they
purchased insurance on their own; However, some question whether the
tax subsidy for health insurance is the best way to increase health
insurance coverage. For example, the tax exclusion provides the most
assistance to taxpayers who have high marginal tax rates (those with
high incomes)--the exclusion saves those taxpayers more in taxes owed
than it saves those with lower marginal tax rates; The tax exclusion
for health insurance also contributes to higher health care costs. The
exclusion, by lowering premiums, encourages more extensive insurance
coverage, which compounds another well-known problem with health
insurance. Because much of the cost of medical treatment is paid for by
a third party (the insurer), patients and doctors are generally unaware
of the total costs of health care and have little incentive to
economize on health care spending; Unlike the tax exclusion for
employer-provided health insurance, an ideal health care payment system
would foster the delivery of care that is both effective and efficient,
resulting in better value for the dollars spent on health care.
[End of text box]
Tax revenue can also be affected by changes in tax rates, where the
amount collected depends on the definition of the tax base and taxpayer
responses to changes in the rate. If the tax base is broad with few
exclusions, deductions, and credits, then the tax rates required to
generate a particular amount of revenue will be lower than if the base
is narrow. The Tax Reform Act of 1986 broadened the current tax base,
which is based largely on income, by eliminating some tax expenditures,
which made more income taxable. Without any changes in rates, tax
revenue would have increased, but instead, rates were lowered to keep
revenue about the same. Within some range, rate increases bring in more
revenue, but rates can become so high that a further increase
discourages enough of the taxed activity to reduce revenue. A tax
system is more adaptable to increased revenue needs to the extent that
tax rates can be increased without other fundamental changes to the
system and without excessively discouraging the taxed activity or
increasing noncompliance.
Tax revenue is also affected by policies that change compliance rates.
Noncompliance means that only part of the tax liability actually gets
paid. Increasing compliance would bring in more revenue from the
existing tax base without having to raise rates. IRS estimates that the
net tax gap (the difference between taxes legally owed to the
government and what taxpayers actually paid to the government) was at
least $257 billion in 2001, the most recent year available. This is
about 13 percent of federal revenue. Some experts believe that
simplicity and transparency can contribute to compliance, as voluntary
compliance is likely to increase if taxpayers are less likely to make
errors on their tax returns and have fewer opportunities to evade
taxes.
While federal tax policy changes may alter the amount of revenue
collected by the federal government these changes can also alter the
amount of revenue that state and local governments collect. State and
local governments collect nearly one-third of all the tax revenue
generated in the United States each year.
In many cases, state governments link their tax bases to the federal
tax base. For example, some states use a taxpayer's adjusted gross
income from the federal tax return to calculate state income taxes. If
the federal government enacted provisions that reduce the size of the
tax base used to calculate a taxpayer's adjusted gross income, then
absent policy changes in the affected states, these state governments
would likely see a decrease in state tax revenues. Conversely, if the
federal government reduced the number of tax expenditures, increasing
the size of the tax base, state governments would likely see an
increase in state tax revenues. Thus, major changes to the federal tax
base could lead to a variety of challenging tax system changes at the
state level. For example, if the federal government adopted a
consumption tax base, many states may have to consider whether they
wish to maintain state income taxes.
General Options Suggested for Fundamental Tax Reform:
Recent years have seen a variety of proposals for fundamental tax
reform. These proposals would significantly change the tax base, tax
rates, and collection points of the tax.
Some of the proposals would replace the federal income tax with some
type of consumption tax. The retail sales tax, value-added taxes, the
personal consumption tax, and the flat tax are all types of consumption
taxes. They vary in their collection points and structure. Similarly,
collection points and rate structure will vary under an income tax
base.
Text box 2 briefly summarizes the general categories of proposals.
Text Box 2: General Categories of Tax Reform Proposals; In recent
years, lawmakers and analysts have suggested a variety of tax reform
proposals that would change the way in which Americans pay taxes;
* National retail sales tax (NRST): An NRST would be collected by
businesses with, in most cases, no need for individuals to file tax
returns (some taxpayers may be required to file tax returns in order to
get back taxes that they paid on items for business use). The base
would be retail sales of goods and services to final customers. Rates
could not vary by individual;
* Value-added taxes (VAT): VATs, now widely used in other countries,
are collected by businesses with no need for individual tax returns.
The VAT taxes all sales to both consumers and other businesses,
adjusting for purchases from other businesses, which is equivalent to
the base of an NRST. Rates do not vary by individual. Some experts
believe a VAT would be easier to enforce than an NRST;
* Flat tax: A consumption flat tax would have the same base as an NRST
or a VAT but would split collection between businesses and individuals
by making wages deductible by businesses but taxable at the individual
level. Generally, a single tax rate would apply to both individuals and
businesses. Because of the individual component of the tax, wages up to
some level can be exempted from tax, which would introduce some
progressivity into this tax system;
* Personal consumption taxes: A personal consumption tax would look
much like the current individual income tax. Individuals would report
their income from wages, interest, dividends, and so on. It would
differ in that borrowed funds would be included in the tax base, and
funds that are saved or invested would be deducted. The base is
equivalent to that of other consumption taxes. Rates could vary based
on individual characteristics;
* Reformed income tax system: Over the years, the Department of the
Treasury and others have discussed options for reforming the current
tax system that would replace the current income tax with a more
broadly based income tax. For example, proposals have been advanced to
integrate the personal and corporate income tax and to eliminate
preferences on certain types of income, which would broaden the tax
base and could result in reduced tax rates (if the proposal were
revenue neutral).
[End of text box]
Key Questions:
1. What current taxes would the proposal change?
* Does the proposal change personal income taxes, social insurance
taxes, corporate income taxes, and/or estate and gift taxes?
2. What is the nature of the proposed change to the tax system?
* Does the proposal change the tax base from income to consumption?
* Does the proposal include tax expenditures?
* Does the proposal change the tax rates?
* Does the proposal change the collection points for the tax?
3. How will the proposed change affect total revenues?
* Are proposed changes to the tax code likely to be revenue neutral?
* If not, will they generate more or less revenue than the current tax
laws?
4. What effect would the proposal have on the nation's projected
budgets and long-term fiscal outlook?
* Does the proposal take into consideration the sizable long-term
fiscal gap that the country faces?
5. What tax expenditures are included in the proposal, and what tax
expenditures, if any, have been removed from the current tax system?
* Are the social and economic goals of the tax expenditures likely to
be achieved and worth the cost in lost revenue?
* When the total costs of a program are considered, would it be less
costly to implement the program as a tax expenditure or as a spending
program?
6. If the proposal changes the tax base, the tax rates, or the
collection points, how would these changes alter the amount of revenue
that the government is able to collect?
7. What implications, if any, would the proposal have on the ability of
state and local governments to collect tax revenues?
* Would the proposal tax the same base that many states rely on?
* Would the proposal allow many states to continue to rely on the
federal tax base as a starting point for determining state taxes?
[End of section]
Section 2: Criteria for a Good Tax System:
How should a tax system be designed to raise a given amount of revenue?
More specifically, what criteria should be used to evaluate the
advantages and disadvantages of a particular tax system, or a
particular tax policy proposal? The answers matter because various
combinations of tax bases and rates can raise the same amount of
revenue.
Three long-standing criteria--equity; economic efficiency; and a
combination of simplicity, transparency, and administrability--are
typically used to evaluate tax policy. These criteria are often in
conflict with each other, and as a result, there are usually trade-offs
to consider between the criteria when evaluating a particular tax
proposal. Some of the criteria, such as equity and transparency, are
more subjective while other aspects of some of the criteria, such as
economic efficiency, can be defined more objectively. Additionally,
people may disagree about the relative importance of the criteria.
Consequently, citizens and elected officials are likely to hold a wide
range of opinions about what the ideal tax system should look like.
(See fig. 9.)
Figure 9: Trade-offs in the Criteria for Assessing Tax Reform:
[See PDF for image]
[End of figure]
In the following sections, we explain these criteria. The fact that a
particular tax is viewed favorably from the perspective of one of the
criteria is not an overall endorsement of the tax.
Equity:
There are a wide range of opinions regarding what constitutes an
equitable, or fair, tax system. There are principles--a taxpayer's
ability to pay taxes and who receives the benefits from the tax revenue
that is collected--that are useful for thinking about the equity of the
tax system. However, these principles do not change the fact that
conclusions about whether one tax is more or less equitable than
another are value judgments. Similarly, analytical tools, such as
distributional analysis, while providing useful factual information
about who pays a tax and how much they pay, do not replace individuals'
value judgments about what constitutes a fair tax system. (See fig. 10.)
Figure 10: Equity Overview:
[See PDF for image]
[End of figure]
Equity Principles:
Two principles of equity underlie debates about the fairness of
different tax policies. The ability to pay principle and the benefits
received principle do not identify one tax policy as more equitable
than another, but they can be used to clarify and support judgments
about equity. When making judgments about the overall equity of
government policy, it is important to consider both how individuals are
taxed and how the benefits of government spending are distributed. Even
if some judge tax policy to be inequitable, government policy as a
whole may be considered more equitable once the distribution of both
taxes and government benefits is accounted for. For the purposes of
this report, we have confined our discussion of equity to the
distribution of tax burdens.
Ability to Pay Principle:
The ability to pay principle states that those who are more capable of
bearing the burden of taxes should pay more taxes than those with less
ability to pay. The ability to pay principle relates taxes paid to some
measure of ability to pay, such as overall wealth, income, or
consumption. However, ability to pay may vary depending on the measure
chosen. For example, a taxpayer's ability to pay, measured by overall
wealth, may differ significantly from his or her ability to pay
measured by income. A taxpayer who worked for many years and then
retired may have accumulated a significant amount of wealth and may, as
a result, have a higher ability to pay taxes but may have low current
income.
Some features of the current income tax can be viewed as reflecting
attempts to account for differences in ability to pay. For example, two
taxpayers with the same income may not have the same level of economic
well-being--the same ability to pay--if one has high medical expenses
and the other does not. For this reason, the current income tax allows
deductions for large medical expenses. Other provisions of the tax
code, such as the deduction for the number of dependents, may also
adjust income to better reflect ability to pay. Some items that clearly
affect ability to pay, such as the contribution provided by a
nonworking spouse to a family's well-being, are not included in taxable
income, in part because of difficulties in valuing these aspects of
economic well-being. People have different views about the factors that
affect ability to pay.
Additionally, some do not agree that income is the best measure of
ability to pay. As noted above, some argue that consumption provides a
better measure of a taxpayer's ability to pay taxes than income.
Horizontal and Vertical Equity:
The concepts of horizontal equity and vertical equity are refinements
of the ability to pay principle.
Horizontal equity requires that taxpayers who have similar ability to
pay taxes receive similar tax treatment. Targeted tax expenditures,
such as deductions and credits, could affect horizontal equity
throughout the tax system because they may favor certain types of
economic behavior over others by taxpayers with similar financial
conditions. For example, two taxpayers with the same income and
identical houses may be taxed differently if one owns his or her house
and the other rents because mortgage interest on owner-occupied housing
is tax deductible.
Vertical equity deals with differences in ability to pay. Subjective
judgments about vertical equity are reflected in debates about the
overall fairness of the following three types of rate structures, where
for this example, income is used as the measure of ability pay:
* Progressive tax rates: The tax liability as a percentage of income
increases as income increases.
* Proportional tax rates: Taxpayers pay the same percentage of income,
regardless of the size of their income.
* Regressive tax rates: The tax liability is a smaller percentage of a
taxpayer's income as income increases.
Just because the statutory rate structure for a tax is progressive does
not necessarily mean that the tax system is progressive overall. For
example, when considering an individual income tax, if statutory
marginal tax rates increase as taxable income increases the tax rate
structure is progressive. However, as shown in text box 3, statutory
tax rates are not the same as effective tax rates--progressive
statutory tax rates could be offset by other features of the tax
system. Average effective tax rates, or the amount of tax that a
taxpayer actually pays as a percentage of his or her total income
(after deductions, credits, and exclusions are removed from the
equation) may make the tax less progressive if there are a variety of
provisions in the tax code that reduce the taxable income of wealthier
taxpayers.
Text Box 3: Examples of Different Types of Tax Rates; Conclusions about
the overall equity of the tax system may be different depending on
which type of tax rate one considers; Statutory tax rates are the tax
rates that are defined by law in the tax code and applied to taxable
income. Effective tax rates differ from statutory tax rates in that
they are typically measured using a broader definition of income, which
includes items excluded under the current tax code in order to provide
an estimate of what a taxpayer pays in relation to his or her overall
total income; Marginal tax rates are the rates that taxpayers pay on
the next dollar of income that is earned. Marginal tax rates can be
presented as both marginal statutory rates and marginal effective
rates. Average tax rates are the total amount of tax a taxpayer pays
divided by some measure of his or her income. In the current tax
system, average tax rates are sometimes presented as the amount of tax
a taxpayer pays divided by his or her taxable income. Average effective
tax rates differ in that they are developed using a broader measure of
total income than taxable income; The following tax rates are often
discussed when considering the equity of the tax system;
* Marginal statutory tax rates: The tax rate that a taxpayer pays on
his or her next dollar of income earned as defined by law in the tax
code;
* Marginal effective tax rates: The actual rate of tax that a taxpayer
faces on the next dollar of income earned when all other provisions of
the tax (deductions, credits, etc.) are included;
* Average effective tax rates: The overall rate of tax a taxpayer pays
as a percentage of his or her total income after all other provisions
of the tax system (deductions, credits, etc.) are included; Conclusions
about the progressivity of the tax system may differ, for example,
depending upon whether they are based on an examination of the
statutory marginal rate structure or on the effective marginal rate
structure.
[End of text box]
People hold different opinions as to whether the current rate structure
is vertically equitable. Some believe that the rate structure should be
more progressive, and that effective tax rates should rise with income
more rapidly than they do under the current system. Others support a
proportional rate structure. They believe that a tax system that
imposes a single flat tax rate on income is more equitable because each
additional dollar earned is taxed at the same rate.
Benefits Received Principle:
In contrast to the ability to pay principle, the benefits received
principle states that the amount of tax paid should be directly related
to the benefits that a taxpayer receives from the government. In
practice, the benefits received principle requires the government to
identify who benefits from specific government services. As a result,
the benefits received principle is usually not applicable when
considering government programs intended to provide societywide
benefits or redistribute wealth.
The federal tax on gasoline is an example of a tax that is sometimes
justified on the benefits received principle. Gas taxes are paid by
road users. This means that the people who pay the tax (drivers) are
the same taxpayers who receive the benefits from the revenue collected
in the form of both new and improved highways. User fees, such as
postage stamps or fees to enter national parks, are another example of
taxes based on the benefits received principle.
Measuring Who Pays: Distributional Analysis:
Distributional analysis, which shows tax burden by differing income
groups, is used to measure how different tax proposals would affect
taxpayers with varying ability to pay, or the way in which the tax
burden is to be shared among various income groups. Some tax reform
proposals may alter the distribution of taxes paid among various groups
of taxpayers, while other tax reform proposals may be distributionally
neutral, or maintain the same distribution of tax burdens as the tax
system that is already in place. The Tax Reform Act of 1986 is an
example of a tax reform proposal that was intended to be
distributionally neutral.
The distributional analyses of a specific tax proposal may differ for a
variety of reasons. Among the most important are (1) the time period
included in the analysis, (2) the manner in which ability to pay is
measured, (3) the unit of analysis, (4) assumptions regarding tax
incidence, (5) the taxes included in the analysis, and (6) the measures
of tax burden used in the table.
Time period of the analysis: Most distributional analysis tables use
annual measures of income and taxes, although some use longer periods.
However, a 1-year time horizon provides a limited perspective on the
distributional effects of federal taxes. For example, consider the same
individual at different points in his or her life. When he or she
enters the workforce, income and wealth usually are relatively low but
increase over time when prime earnings years are reached and assets and
savings begin to be accumulated. With retirement, annual wages fall and
savings are the primary support for the retirees lifestyle. As a result
of fluctuations in income over time, annual tables measuring the
distribution of tax burdens may group together people who have
different lifetime economic circumstances.
Ability to pay measure: Most studies that measure distributional
effects of alternative tax proposals include a broad measure of income
that includes more than just taxable income to measure a taxpayer's
ability to pay. Some types of nonwage income, such as investment
income, are relatively easy to identify and include in distributional
tables, while others are more difficult. For example, distributional
analyses may attempt to adjust for such factors as the value of
employer-provided fringe benefits in order to broaden the definition of
income to better reflect ability to pay.
However, while income is the most commonly used measure of ability to
pay in distributional analysis, other measures of ability to pay, such
as consumption, may also be used to create distributional tables. As we
mentioned earlier, some believe that consumption is a better measure of
ability to pay taxes than income.
Unit of analysis: The unit of analysis used to group taxpayers together
may also affect the outcome of distributional tables. Some analysts
create distributional tables using individual taxpayers as the unit of
analysis, while others group taxpaying units (people included on a tax
return, families, or households) together. Distributional tables may
differ if one table uses individual taxpayers and another table uses a
taxpaying unit because a taxpaying unit may include more than one
individual who pays taxes.
Tax incidence: The actual burden of a tax does not always fall on the
people or businesses that actually pay the tax to the government, and
assumptions about tax incidence may affect the results of
distributional tables. The statutory incidence of a tax--the parties
who are legally required to pay the tax--may not be the same as its
economic incidence--the parties who actually bear the burden of the
tax--because taxpayers who legally must pay the tax can sometimes shift
the burden to others through changes in prices, wages, and returns on
investments. For example, from a statutory perspective, the employee
and employer contribution to the payroll tax are equal. However, most
analysts agree that employees bear the entire burden of the payroll tax
in the form of reduced wages.
Determining who bears the burden of the corporate income tax is an
example of how difficult it can be to determine the incidence of a tax.
Text box 4 illustrates some of the issues associated with identifying
the incidence of the corporate income tax.
Text Box 4: Incidence of the Corporate Income Tax; Corporations do not
actually bear the ultimate burden of the corporate income tax; instead,
individuals bear the burden of the corporate income tax. A corporation
writes a check to the U.S. Treasury to pay its tax liability, but the
burden of the tax is shifted to other groups of people through lower
incomes or higher prices;
The money to pay the tax must come from reduced returns to investors in
the corporation, lower wages to the company's employees, or higher
prices that consumers pay for the company's products. In the short
term, the incidence of the corporate income tax is likely to fall on
stockholders or investors in general. However, because corporate income
taxes may lead to reduced capital investment, in the longer term some
of the burden of the corporate income tax is more likely shifted to
people who earn income from labor. Reduced capital investment can lead
to lower productivity and, consequently, lower wages;
Due to the difficulty of identifying the incidence of the corporate
income tax, some, including the Joint Committee on Taxation, often
exclude the corporate income tax from distributional tables altogether.
[End of text box]
Taxes included in the analysis: Some distributional tables include
different taxes in the analysis, so when comparing two distribution
tables, identifying which taxes are included in the analysis is
necessary to ensure that a valid comparison can be made between the two
estimates. For example, in table 3, one side of the table includes all
federal taxes, while the other side only includes the federal income
tax. Because it is often difficult to isolate the incidence of some
taxes, analysts sometimes exclude those taxes from the analysis.
Measures of tax burden: Distributional tables may also produce
different results based on the measures of tax burden that are used.
Effective tax rates and share of tax liability (portion of total taxes
that households in each quintile collectively remitted to the
government), the measures used in table 3, are two common measures of
tax burden. Some distributional tables show how effective tax rates
would change if the tax code were changed.
Different Assumptions Lead to Different Distributional Analyses:
The Office of Tax Analysis in the Treasury Department, the
Congressional Budget Office (CBO), and the Joint Committee on Taxation
are the three government sources of tax distributional analysis, and
their distributional tables may differ based on the assumptions that
they make about the issues we have outlined above.
The example in table 3, which shows two measures of tax burden,
illustrates the fact that making different assumptions when conducting
distributional analysis can lead to different results.
Table 3: Measures of Tax Burden: Distribution of Total Federal Taxes
and Individual Income Taxes in 2004:
Income quintiles: Lowest quintile;
Total federal taxes: Effective tax rates: 5.2%;
Total federal taxes: Share of tax liability: 1.1%;
Individual income taxes: Effective tax rates: -5.7%;
Individual income taxes: Share of tax liability: -2.7%.
Income quintiles: Second quintile;
Total federal taxes: Effective tax rates: 11.1%;
Total federal taxes: Share of tax liability: 5.2%;
Individual income taxes: Effective tax rates: -0.1%;
Individual income taxes: Share of tax liability: -0.1%.
Income quintiles: Middle quintile;
Total federal taxes: Effective tax rates: 14.6%;
Total federal taxes: Share of tax liability: 10.5%;
Individual income taxes: Effective tax rates: 3.5%;
Individual income taxes: Share of tax liability: 5.4%.
Income quintiles: Fourth quintile;
Total federal taxes: Effective tax rates: 18.5%;
Total federal taxes: Share of tax liability: 19.5%;
Individual income taxes: Effective tax rates: 6.6%;
Individual income taxes: Share of tax liability: 15.2%.
Income quintiles: Highest quintile;
Total federal taxes: Effective tax rates: 23.8%;
Total federal taxes: Share of tax liability: 63.5%;
Individual income taxes: Effective tax rates: 14.2%;
Individual income taxes: Share of tax liability: 82.1%.
Income quintiles: All;
Total federal taxes: Effective tax rates: 19.6%;
Total federal taxes: Share of tax liability: 100.0%;
Individual income taxes: Effective tax rates: 9.0%;
Individual income taxes: Share of tax liability: 100.0%.
Source: Congressional Budget Office, Effective Federal Tax Rates Under
Current Law, 2001 to 2014 (Washington, D.C.: August 2004).
Note: In table 3, numbers do not always add due to rounding.
[End of table]
Both of the distribution tables were prepared by CBO using the same
methodology to measure the distributional effects of the tax system in
2004 using 2001 income (adjusted for inflation and nominal income
growth to reflect income in 2004) as the base for the analysis. The
only difference between the left side of the table and the right side
of the table is the taxes that are included in the analysis. The left
side includes total federal taxes, excluding estate and gift taxes and
several other miscellaneous sources of revenue, while the right side of
the table only includes individual income taxes. The table that
presents total federal taxes uses the assumption that individuals bear
the burden of the employee and employer share of payroll taxes, and
owners of capital income bear the burden of the corporate income tax.
The effective tax rates for individual income taxes are negative for
the two lowest income quintiles because the table includes some offsets
to tax liability, such as the earned income tax credit.
Key Questions:
1. How is a taxpayer's ability to pay broadly defined:
* Income?
* Consumption?
* A broader definition of overall wealth?
2. What factors other than income, such as medical expenses, number of
dependents, and so forth, does the proposal account for when
considering a taxpayer's ability to pay taxes?
3. Will taxpayers with equal ability to pay taxes pay the same amount?
* If not, what provisions of the proposal do not adhere to the
principle of horizontal equity?
4. How will the tax system tax people with differing ability to pay?
* Are the statutory tax rates progressive, proportional, or regressive?
* Are the average effective tax rates progressive, proportional, or
regressive (accounting for credits, deductions, and other tax
expenditures)?
5. Are there any components of the tax proposal that are justified on
the benefits received principle?
* If so, what mechanisms are in place to determine that taxpayers who
pay taxes for a particular government program are the same taxpayers
who benefit from the provisions of that program?
6. Does the proposal maintain the distribution of taxes (i.e., is the
proposal distributionally neutral)?
* If not, who will be paying more in taxes and who will be paying less?
* If so, what features of the proposal are in place to ensure that it
will remain distributionally neutral?
7. What type of distributional analysis was done?
* What time period is covered? For example, does the distributional
analysis measure the lifetime or annual effects of the tax system?
* How is ability to pay (income, consumption, or wealth) measured?
* What is the unit of analysis (individuals, households, or taxpaying
units)?
* What assumptions are made about tax incidence (e.g., who is assumed
to pay the corporate income tax)?
* What taxes are covered in the distributional analyses?
* What measures (e.g., tax rates, share of tax liability) are being
used to calculate the distribution of tax burden?
Economic Efficiency:
One reason people bear taxes is they desire the benefits of government
programs and services. As taxpayers, they balance the costs of taxes
with the benefits of government. From a taxpayer's perspective, the
cost of taxes includes more than the tax liability paid to the
government. These costs include efficiency costs, which result from
taxes changing the economic decisions that people make--decisions such
as how much to work, how much to save, what to consume, and where to
invest. These changes, referred to by economists as distortions, reduce
people's well-being in a variety of ways that can include a loss of
output or consumption opportunities. These reductions in well-being are
efficiency costs, also called deadweight losses, excess burdens (excess
because they are a cost in addition to the tax liability), or welfare
losses.
Because taxes generally create inefficiencies, minimizing efficiency
costs is one criterion for a good tax. However, the goal of tax policy
is not to eliminate efficiency costs. The fact that taxes impose
efficiency and other costs beyond the tax liability does not mean that
taxes are not worth paying. The goal of tax policy is to design a tax
system that produces the desired amount of revenue and balances
economic efficiency with other objectives, such as equity, simplicity,
transparency, and administrability. Moreover, as noted in the revenue
section, the failure to provide sufficient tax revenues to finance the
level of spending we choose as a nation gives rise to deficits and
debt. Large sustained deficits could ultimately have a negative impact
on economic growth and productivity.
Because taxes impose efficiency costs, the total cost of taxes to
taxpayers is larger than their tax liability (the check they send to
the U.S. Treasury). The total cost of taxes from a taxpayer's point of
view is the sum of the tax liability, the efficiency costs, and the
costs of complying with the system (which we discuss later), as shown
in figure 11.
Figure 11: Efficiency Costs Are One Cost Taxpayers Face in Complying
with the Tax System:
[See PDF for image]
[End of figure]
From a national perspective tax revenue is not a cost. Tax revenue is
not lost to the nation--it is moved from taxpayers' pockets to the
Treasury in order to pay for the programs and services that the
government provides. On the other hand, efficiency costs and compliance
burden are costs from a national perspective because, for example, they
can result in forgone production and consumption opportunities, as well
as the loss of taxpayers' time spent on complying.
Tax systems can differ in the magnitude and nature of their efficiency
costs. Differences in the base, rates, preferences, or tax-induced
responses can all affect the extent one tax distorts when compared to
another. Tax systems can cause distortions that affect both individual
taxpayers and businesses. Figure 12 outlines some of the key issues to
consider when thinking about the efficiency of the tax system.
Figure 12: Efficiency Overview:
[See PDF for image]
[End of figure]
Equity concerns may force a trade-off between fairness and efficiency.
Progressive tax rate schedules are believed to have higher efficiency
costs than a proportional schedule that raises the same amount of
revenue. However, proponents of progressive rates are willing to trade
off some efficiency in order to gain, in their view, more vertical
equity. As will be shown below, efficiency costs, although they are
hard to measure, often can be defined objectively. Nevertheless, they
still must be balanced with the more subjective criteria like equity
when reaching general conclusions about a tax proposal.
Taxes and Economic Decision Making:
Economic efficiency can be thought of as the effectiveness with which
an economy utilizes its resources to satisfy people's preferences.
Economists generally agree that (from the perspective of efficiency and
ignoring other considerations, such as equity) markets are often the
best method for determining what goods and services should be produced
and how resources should be allocated. Self-interest is assumed to
motivate resource owners to try to use their resources in a manner that
realizes the highest return. When resources are directed to their
highest valued uses the economy is said to be efficient.
Inefficiencies reduce the economic well-being of people in the
aggregate, since resources are not directed to their highest valued
uses. By reallocating resources from lower valued uses to higher valued
uses, the economic well-being of people can be increased. However,
gains from reallocating resources from lower valued uses to higher
valued uses may not be distributed in manner considered fair, that is,
some people may lose because of the reallocation.
Generally, taxes alter or distort decisions about how to use resources,
creating economic inefficiencies. By changing the relative
attractiveness of highly taxed and lightly taxed activities, taxes
distort decisions such as what to consume, how much to work, and how to
invest. Households and firms generally respond to taxes by choosing
more of lower taxed items and less of higher taxed items than they
would have otherwise. The change in behavior can ultimately leave
individuals with a combination of consumption and leisure that they
value less than the combination that they would have chosen under a tax
system that does not distort their behavior.
As a simple example of the effects of a tax distortion, suppose an
investor is choosing between two investments, one that has an expected
annual return of 10 cents on every dollar invested and a second that
has an expected annual return of 15 cents. If the income from neither
investment is taxed, or if the income is taxed equally, the investor
will choose the second investment with its higher economic rate of
return. However, if the first investment continues to be untaxed, while
the second is subject to a 40 percent tax, the decision will be based
on the investment's after-tax rate of return. In this case the after-
tax return on the first investment continues to be 10 cents for every
dollar invested, while the after-tax return on the second investment is
now 9 cents. An investor would choose the first investment because it
has a higher after-tax return. However, this results in a loss to the
economy, or inefficiency. Society gains a 10 cent return from the first
investment, all of which goes to the investor. Society would have
gotten the 15 cent return from the second investment, 9 cents for the
investor, and 6 cents for the government.
Note that a tax does not actually have to raise revenue to cause
inefficiencies. In the previous example, the investor who chose the
first investment would pay no tax. However, the tax system design has
distorted the investor's decision-making and reduced output.
The example of the tax-preferred treatment of owner-occupied housing
illustrates a trade-off between efficiency costs and using the tax
system to achieve other social goals. Text box 5 presents some
estimates of the efficiency costs of the tax treatment of owner-
occupied housing due to large differences in effective tax rates across
three major investment categories. However, even in situations such as
the one outlined in the text box, where the tax preference imposes some
efficiency costs, there may still be valid reasons for using tax
preferences as a tool of government for achieving certain social and
economic goals. As we note in the example, most economists agree that
the tax-preferred treatment of owner-occupied housing distorts
investment patterns in the economy. The tax preference promotes the
social goal of increased home ownership--a goal that many policymakers
advocate.
Text Box 5: Tax Treatment of Owner-Occupied Housing Distorts Investment
Choices and Lowers Wages:
Compared to other types of investment, owner-occupied housing enjoys
tax advantages primarily because the value that homeowners receive from
housing services, which is a part of the return on their investment in
housing, is excluded from taxation. Economists view these services,
called imputed rent, as income in kind, which is valued at what the
homeowner would receive as income if the house was rented. Under a pure
income tax, imputed rent net of such costs as mortgage interest would
be taxed. This tax treatment would help insure that investment in
housing is taxed as other investments are taxed. As the table below
shows, the tax advantages under the current system lead to lower
marginal effective tax rates (METR) for housing relative to other
investments.
METRs on Capital Income, by Source, in 2003.
* Owner-occupied housing: 2%;
* Noncorporate investment: 18%;
* Corporate investment: 32%.
Source: Jane Gravelle, "The Corporate Tax: Where Has It Been and Where
Is It Going?" National Tax Journal, vol. 57, no. 4 (2004): 903-23.
Economists generally agree that the favorable treatment of owner-
occupied housing, by lowering METR, distorts investment in the economy,
resulting in too much investment in housing and too little business
investment. The consequence of this is that businesses invest less in
productivity- enhancing technology. This in turn results in employees
receiving lower wages because increases in employee wages are generally
tied to increases in productivity;
The resulting distortions from the tax- preferred treatment of owner-
occupied housing lead to efficiency costs that have been estimated to
be large. Gravelle's summary of estimates reports that the efficiency
costs of the tax-preferred treatment of owner-occupied housing could be
as much as 0.1 to 1 percent of GDP;
In addition to efficiency concerns, the tax treatment of owner-occupied
housing also raises equity concerns. The current exclusions from income
are more valuable to taxpayers in high tax brackets. Taxpayers in lower
brackets receive a less valuable homeownership subsidy or no subsidy at
all.
[End of text box]
Although taxes generally result in efficiency losses, there are
exceptions. In special cases, tax distortions may offset other
inefficiencies, which can be caused by what economists call market
failures. An example is an externality or spillover, where the benefits
or costs of an activity are not fully captured by the individuals or
firms undertaking the activity. Research and development is commonly
cited as generating positive externalities--in some cases, the entity
doing the research and development may produce knowledge that enters
the public realm and is freely available to users. For example, some
medical innovations, such as surgical techniques, cannot be patented.
To the extent that benefits cannot be sold in a market, private firms
that innovate will not reap the full financial benefits of the
innovation and, therefore, will invest too little in research. Tax
incentives for research might be one way to address the problem, but
other governmental tools such as grants, loans, or regulations could
also be considered. Efficient taxes are special cases--tax systems
large enough to fund the federal government impose efficiency costs.
Measuring Economic Efficiency:
While economists generally agree that the tax system imposes
significant efficiency costs, estimating the magnitude of tax-related
efficiency costs in an economy as complex as ours is extremely
difficult. However, several attempts have been made to estimate the
efficiency costs of parts of the tax system. For example, one study
estimated the total efficiency cost of the personal income tax on labor
income, which distorts labor supply decisions, to be from $137 billion
to $363 billion in 1994.[Footnote 3] A second study estimated the
effects of the unequal taxation of savings and consumption to be about
$45 billion in 1995.[Footnote 4] Text box 5 summarized estimates of the
efficiency losses associated with the tax treatment of owner-occupied
housing as ranging from 0.1 to 1 percent of GDP. For further
information on efficiency cost estimates, see GAO, Tax Policy: Summary
of Estimates of the Costs of the Federal Tax System, [Hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-878] (forthcoming).
These partial estimates indicate the significant uncertainty
surrounding the magnitude of tax-induced efficiency costs.
Nevertheless, they suggest that the overall efficiency costs imposed by
the tax system are large--on the order of several percentage points of
GDP.
As a result of these difficulties, simple rules of thumb are commonly
used to provide rough estimates of the efficiency costs of taxes. Text
box 6 describes two such rules of thumb.
Text Box 6: Rules of Thumb for Estimating Efficiency Costs;
Because of the difficulty of measuring efficiency costs, several rules
of thumb have been used to approximate efficiency costs in certain
situations. These rules suggest that efficiency costs from taxes may be
considerable;
Two commonly cited rules are as follows:
* According to OMB guidance, the efficiency cost of a tax increase,
which should be included as part of the total cost when calculating the
benefits and costs of a government spending project, is equal to 25
percent of the tax revenue collected used to fund the project.
* Some economists agree that the efficiency cost of a tax increases
with the square of the tax rate: a 50 percent tax increase, for
example, from 25 percent 37.5 percent, would more than double the
efficiency cost. For this reason, progressive tax rate schedules, which
have higher top marginal rates, are believed to have higher efficiency
costs than a proportional schedule that raises the same amount of
revenue.
[End of text box]
The extent to which tax reform can reduce such tax-induced
inefficiencies and thus increase our economic well-being depends on the
design of a reformed system. All practical tax systems distort some
decisions so it is not possible to eliminate all the efficiency costs
associated with taxes. The magnitude of the efficiency costs in a
reformed tax system would depend on such design features as the
treatment of savings versus consumption, the number of tax
expenditures, and the level and progressivity of tax rates. While some
economists believe that a pure consumption tax with no preferences and
a flat rate would reduce efficiency costs relative to the current tax
system, such a pure tax may not be a feasible alternative because of
equity and other concerns.
In addition, as has been discussed, the revenue consequences of tax
reform have economic effects. The efficiency gains from a reformed tax
system could be offset if the new system increases long-term deficits.
Taxing Work and Savings Decisions:
In part because of the difficulty of measuring the efficiency cost of
taxes, discussions of the impact of taxes on the economy sometimes
focus on the effect that taxes have on changes in the output of the
economy, labor supply, or other such economic variables. However, such
changes do not necessarily measure efficiency costs. Efficiency loss is
the difference between individuals' well-being with a tax and
individuals' well-being under a revenue neutral, hypothetical tax that
does not distort, called a lump sum tax.
Three choices commonly discussed are the choice between work and
leisure, the choice between consumption and saving, and the choice
between domestic and foreign investment. Intertwined with effects that
taxes have on these choices is the effect of taxes on economic growth.
Work versus leisure: Taxes--both income and consumption taxes--can
affect the decisions that people make about how much time to devote to
work or leisure in two ways. First, taxes may increase the incentive to
work because workers must work more to maintain their after tax income.
Second, taxes may reduce the incentive to work because workers earn
less from an additional hour of work. The net effect may be no change
to the overall supply of labor. However, even in this case, there is
still an efficiency cost, which is determined by the second effect. By
reducing hourly after tax earnings, income and consumption taxes
distort decisions about how many hours to devote to work or leisure.
Empirical research generally shows that at least for primary wage
earners, decisions about labor force participation are not very
responsive to taxes. However, decisions about labor force participation
by secondary wage earners have been shown to be more responsive to
changes in the tax system.
Consumption versus savings: Taxes on capital reduce the after-tax
return to savings. In effect, this makes future consumption (savings)
more expensive relative to current consumption and thus has the
potential to distort savings decisions. While research has shown that
the demand for some types of savings, such as the demand for tax-exempt
bonds, is responsive to changes in the tax system, there is greater
uncertainty about the effects of changes in the tax system on other
choices, such as aggregate savings.
Domestic versus foreign investment: Taxes on income from capital can
affect the location of investment by changing the relative after-tax
return on domestic and foreign investment. This matters because the
location of investment can affect the income of U.S. citizens. The
income of people working in the United States is closely tied to their
productivity, which generally increases with the amount of domestic
investment. At the same time, U.S. citizens who own capital can earn
higher incomes by investing their capital--in the United States or
abroad--wherever it earns the highest rate of return. In a world of
increasing capital mobility due to increasing trade and decreasing
communication and transportation costs, the effect of taxes on the
location of investment is even more important than in the past:
Efficiency and economic growth: Removing or reducing distortions caused
by the tax system can affect the size of the economy. Increasing the
efficiency of the tax system can expand the economy through a temporary
increase in the rate of growth. An increase in efficiency is an
increase in well-being that comes from using existing resources in a
better way. Efficiency raises capacity to a higher level but does not
necessarily continue to increase it without additional resources. Such
an increase could show up as a temporary increase in the growth of the
economy. However, the long-term growth rate depends on the rates of
change in population, the capital stock, and technology. Changes to the
tax system that would increase economic efficiency could increase the
long-term growth rate if they increase the rate of technological
change. Thus, tax changes that increase economic efficiency may or may
not result in an increased long-term rate of economic growth.
Efficiency versus fiscal effects: As has been discussed, taxes may have
both efficiency effects and fiscal policy effects. Government spending
in excess of government revenues creates deficits, which if large
enough and continued over a period of time will ultimately have a
negative impact on economic growth and productivity to the extent that
they absorb savings that would otherwise finance investment in the
private economy. Thus, the gain from changing the tax system to
increase economic efficiency could be offset if the tax changes
increase the deficit.
Tax policies designed to enhance economic efficiency can be designed
independently of fiscal policy. For example, the Tax Reform Act of 1986
was designed, in part, to achieve increased efficiency by broadening
the tax base and lowering rates in a way that was revenue neutral. Such
a revenue neutral change would have no effect on deficits and debt.
Realizing Efficiency Gains:
The extent to which efficiency gains are realized by switching to an
alternative tax system depends on at least two factors. First, the
efficiency gains of switching to a new tax system depend on the extent
to which that tax system reduces distortions caused by tax preferences,
rate differences, sectoral differences, and switching the base from
income to consumption. Second, the change to a new tax system may not
improve the overall efficiency of the economy if the distorting tax
incentives eliminated by switching to a new tax system are replaced
with government spending or regulation that provides the same
incentives.
Key Questions:
1. Does the proposal tax income, spending, assets, and investments
differentially?
* Which types of income, spending, assets, and investments are tax
preferred?
* Which decisions are likely to be distorted?
2. What social goals, if any, is the tax proposal trying to promote?
* Is there an efficiency justification for the goal, or is the goal
justified on other grounds, such as equity?
3. Do estimates of the cost of achieving the goal include efficiency
costs?
4. What are the trade-offs between equity, efficiency, and the other
criteria?
5. Is the tax proposal accompanied by estimates of the efficiency gains
or losses to be realized by the new tax system?
* Is the tax proposal accompanied by estimates of economic activity
(e.g., change in labor supply or change in GDP) that will be encouraged
or discouraged by the new tax system?
* Is the proposal accompanied by estimates of the efficiency loss or
gain associated with these changes in economic activity?
6. How does the tax change affect leisure versus work decisions?
7. How does the tax change affect savings versus consumption decisions?
8. How does the tax change affect decisions about foreign versus
domestic investment?
9. How does the tax change affect choices between different types of
investments and different types of consumption?
10. Is the tax proposal likely to increase economic growth?
* Is the growth achieved through a onetime rearranging of resources?
* Is the growth achieved through a permanent increase in the rate of
growth?
* Does the tax proposal contain estimates of its effect on growth
(often measured by changes in GDP) and estimates of the costs of
achieving the growth (such as reduced leisure time)?
11. In addition to efficiency effects, will the proposal have other
economic effects by increasing or reducing the deficit?
Simplicity, Transparency, and Administrability:
Simplicity, transparency, and administrability are interrelated and
desirable features of a tax system. Simple tax systems are, in many
cases, the most administrable, and tax systems that are both simple and
administrable are often considered to be the most transparent. However,
even though there is considerable overlap between simplicity,
transparency, and administrability, they are not identical. (See fig.
13.)
Because there is considerable overlap between these concepts, even
though they are not the same thing, we combine simplicity,
transparency, and administrability into one section and discuss them as
a group. While others may not use the same terminology, the debates
implicitly use the same or very similar criteria.
Figure 13: Simplicity, Transparency, and Administrability Overview:
[See PDF for image]
[End of figure]
Simplicity:
Simple tax systems impose less of a compliance burden on the taxpayer
than more complex systems. Taxpayer compliance burden is the value of
the taxpayer's own time and resources, along with any out-of-pocket
costs to paid tax preparers and other tax advisors, invested to ensure
compliance with tax laws. As figure 14 demonstrates, in addition to the
actual tax payments remitted to the government and the efficiency costs
of taxation that we discussed earlier, compliance burden is the third
cost that the tax system imposes on taxpayers. Compliance costs include
the value of time and resources devoted to (1) record keeping, (2)
learning about requirements and planning, (3) preparing and filing tax
returns, and (4) responding to IRS notices and audits. Taxpayers can
either choose to fulfill these responsibilities on their own or they
can hire paid preparers to aid them in complying with the tax code.
According to IRS, over 61 percent of returns filed in 2003 included a
paid preparer's signature, contributing to considerable out-of-pocket
costs to taxpayers.
Figure 14: Compliance Burden Is One Cost Taxpayers Face in Complying
with the Tax System:
[See PDF for image]
[End of figure]
The current tax system has grown increasingly complex over time, and
many believe that taxpayer compliance burden has grown accordingly. The
amount of time that taxpayers actually spend filling out tax forms may
only constitute a small amount of the overall compliance burden. For
many taxpayers, the bulk of the compliance burden comes in the form of
tax planning and record keeping. For example, taxpayers spend time
determining how the growing number of tax expenditures will affect
their respective tax liabilities. The Treasury Department listed 146
tax expenditures in 2004, up about 26 percent since the last major tax
reform legislation in 1986. Frequent changes in the tax code reduce its
stability, contributing to compliance burden by making tax planning
more difficult and increasing uncertainty about future tax liabilities.
Moreover, an increasing number of taxpayers are becoming subject to the
individual AMT. Determining how the provisions of the AMT affect a
taxpayer's tax liability adds to the compliance burden.
Compliance burden is difficult to measure in part because it is
difficult to measure the amount of time taxpayers spend planning and
preparing their returns and the value of that time.[Footnote 5]
Nevertheless, researchers have made several attempts to quantify the
costs that taxpayers incur while complying with the tax system. Most
estimates suggest that taxpayer compliance burden falls between $100
billion and $200 billion each year.
Because compliance burden is difficult to measure, other, less direct
measures of burden are frequently used. These include the number of
pages in the tax code, the number of IRS forms to fill out, the length
of tax instructions, and the number of lines on the tax form. These
measures are believed to be correlated with compliance burden, but the
correlation is recognized to be far from perfect. In some situations,
longer instructions and more details on a form may reduce compliance
burden by clarifying what a taxpayer must do to comply with the tax
laws. These alternative measures of simplicity may provide some insight
into the simplicity of the tax code, but they do not directly measure
the impact that the tax code has on the costs to taxpayers of complying
with the nation's tax laws.
The intergovernmental effects of tax policy changes can also affect
compliance burden. Due to the close links between the federal tax
system and the tax systems in many states, changes to the federal tax
system could have implications for the compliance burden that taxpayers
face when completing their state tax returns. For example, if the
federal government switched from the current income tax system to a
national retail sales tax, or a different type of consumption tax, but
states--most of which have developed income tax forms that are based in
large part on an individual's federal tax return--maintain their income
tax requirements, then overall taxpayer burden would not likely be
greatly reduced. Taxpayers might not have to file federal tax returns,
but many, if not all, of the record keeping and administrative tasks
would still exist when complying with the state-level income tax
requirements.
Transparency:
A transparent tax system is one that taxpayers are able to understand.
Transparent tax systems impose less uncertainty on taxpayers, allowing
them to better plan their decisions about employment, investment, and
consumption. This leads to more confidence that they can accurately
predict their future tax liabilities and contributes to the credibility
of the tax system. Tax systems that are difficult to comply with and
administer may lack transparency. A nontransparent tax system could be
difficult to administer because tax administrators may have difficulty
consistently applying the law to taxpayers in similar situations. In
this sense, transparency is closely linked to the simplicity and
administrability of the tax system. Transparent tax systems include the
following elements:
* Taxpayers can easily calculate their liabilities: Taxpayers can
easily follow instructions and tax rate tables in order to determine
their tax base, their marginal tax rate, and their tax liability to the
government.
* Taxpayers grasp the logic behind tax laws and tax rates: Taxpayers
can look at a tax form or a tax rate schedule and understand lawmakers'
reasoning. For example, whether or not they agree with it, taxpayers
are likely to be able to comprehend the logic behind a progressive rate
schedule.
* Taxpayers know their own tax burden and the tax burden of others:
Irrespective of who actually writes a check to the government,
taxpayers can identify who actually bears the burden of a tax. For
example, the payroll tax is not transparent to the extent that
taxpayers in general are unaware of the incidence of the tax. Even
though payroll taxes are divided equally between employees and
employers, economists generally agree that employees bear the entire
burden of payroll taxes in the form of reduced wages.
* Taxpayers are aware of the extent of compliance by others: Taxpayers
understand the extent to which the tax laws are enforced, meaning that
they know how likely their friends, neighbors, and business competitors
are to actually pay what they owe.
While the concept of transparency is closely linked to simplicity and
administrability, they are not always the same. For example, some tax
provisions may be simple but not transparent. The corporate tax rate
schedule example in table 4 illustrates this. While determining taxable
income under the corporate income tax is often a complex procedure, it
is relatively simple for corporations to calculate their tax
liabilities by referring to tax tables published by the IRS once this
income has been determined. However, the logic underlying the marginal
tax rates in the corporate tax schedule is not transparent. The
marginal rate structure is progressive up to taxable income of
$335,000, but marginal rates then decrease before increasing again and
then decreasing once more.
Table 4: The Corporate Tax Rate Schedule: Simple but Not Transparent:
Tax bracket (taxable corporate income): $0 to $50,000;
Marginal tax rate in the tax bracket: 15%.
Tax bracket (taxable corporate income): $50,001 to $75,000;
Marginal tax rate in the tax bracket: 25%.
Tax bracket (taxable corporate income): $75,001 to $100,000;
Marginal tax rate in the tax bracket: 34%.
Tax bracket (taxable corporate income): $100,001 to $335,000;
Marginal tax rate in the tax bracket: 39%.
Tax bracket (taxable corporate income): $335,001 to $10,000,000;
Marginal tax rate in the tax bracket: 34%.
Tax bracket (taxable corporate income): $10,000,001 to $15,000,000;
Marginal tax rate in the tax bracket: 35%.
Tax bracket (taxable corporate income): $15,000,001 to $18,333,333;
Marginal tax rate in the tax bracket: 38%.
Tax bracket (taxable corporate income): Over $18,333,333;
Marginal tax rate in the tax bracket: 35%.
Source: IRS instructions for Form 1120.
[End of table]
Some experts who have written on transparency believe that the tax
code's transparency has declined in recent years. Numerous tax
provisions have made it more difficult for taxpayers to understand how
their tax liability is calculated, the logic behind the tax laws, and
what other taxpayers are required to pay.
Administrability:
Administrable tax systems allow the government to collect taxes as cost
effectively as possible. Even though tax administration is usually
considered to be IRS's responsibility, taxpayers, employers, and
financial intermediaries such as banks and tax professionals play
important roles in administering the tax code. For example, under the
current system, banks file information returns about the amount of
interest earned by deposit holders that assist IRS in determining tax
liabilities. There is overlap between the simplicity and the
administrability of a tax system, but simple tax systems are not always
easier to administer.
Comparing the Administrability of Tax Systems:
All tax systems have administrative costs. A more administrable tax
system collects more of the statutorily required tax at a lower cost
per dollar collected. However, there are trade-offs between the level
of compliance and administrative costs to IRS. The costs of enforcing
the tax code sufficiently to achieve complete compliance from all
taxpayers are likely to be prohibitive. In addition, the costs of
administrating the tax code are not limited to the budgetary costs of
IRS. As noted above, some of these costs are shared by other parties in
the form of increased compliance burden. Finally, the costs can be
affected by the use of different enforcement policies.
The following summarizes the key tasks required for administering tax
systems:
* Processing tax returns and payments: Currently, IRS processes over
130 million individual income tax returns each year, which taxpayers
file electronically or through the mail. Under today's technology and
any proposed alternatives to the current system, a return-free tax
system may be difficult to implement.
* Enforcing the tax code: Perhaps the government's most challenging
role in administering the tax system is detecting and penalizing
taxpayer noncompliance. Under the current system, withholding and
information reporting are important enforcement tools that generally
increase compliance rates. However, they are not sufficient by
themselves, and IRS devotes considerable resources to collecting taxes
owed but not remitted.
* Providing taxpayer assistance: In order to reduce compliance burden
and increase compliance rates, tax administrators generally provide
assistance to taxpayers by such means as publishing forms and answering
questions.
A tax change proposal may reduce the cost of some administrative tasks
but raise others. Compared to the current personal income tax,
consumption taxes like an NRST or a VAT reduce the number of filers
because only businesses file. As a result, they reduce processing costs
and eliminate the compliance burden on individual taxpayers. However,
other aspects of enforcement costs may increase because administrators
would no longer be able to rely on withholding and information returns
as enforcement tools.
The way the tax system is structured by Congress can affect how it is
administered, and this can affect compliance. For example, taxes
withheld from employees and taxes that have information reporting
requirements have lower income misreporting rates than other taxes. As
figure 15 shows, taxes on wage and salary income, which is subject to
both withholding and information reporting, have the lowest rate of
misreported income; whereas taxes on income from such sources as self-
employment (nonfarm proprietor income) have the highest rate of
misreported income.
Figure 15: Taxpayer Noncompliance Categorized by Amount of Withholding
and Information Reporting, 1992:
[See PDF for image]
[End of figure]
Regardless of the amount of withholding and third-party information
reporting required, other government enforcement activities are likely
to be needed under any proposed tax system in order to ensure that
taxpayers comply with the tax code. Proposals that simplify the tax
code and administrative efforts to aid honest taxpayers in complying
with the tax laws could increase compliance; however, under any system,
costly enforcement efforts, perhaps including face-to-face audits of
taxpayers, will likely always be needed to help detect and penalize
dishonest taxpayers.
Measuring administrative costs is difficult. Budgetary costs are easily
measured: IRS's budget in fiscal year 2004 was $10.2 billion. However,
as discussed earlier, the costs of other parties in tax administration
are harder to determine. Compliance burden estimates range from $100
billion to $200 billion. Despite the uncertainty, the range of
estimates indicates that compliance burden is likely to considerably
outweigh IRS's budgetary costs.
Changes in the technology of tax administration and in the tax code may
have had offsetting and, as yet, unmeasured effects on the costs of tax
administration. On the one hand, recent innovations in computer
software and electronic financial transactions have made it easier to
administer the tax code. On the other hand, since the last major tax
reform initiative in 1986, the number of special rates, credits,
deductions, and other provisions in the tax code have increased. This
added complexity has made the tax code more difficult to administer.
Trade-offs between Equity, Economic Efficiency, and Simplicity,
Transparency, and Administrability:
While the concept of administrability is closely linked to the concepts
of simplicity and transparency, they are not always the same. For
example, a national retail sales tax would be a relatively simple form
of taxation for taxpayers to understand. At the same time, a national
retail sales tax could present administrative difficulties because it
would be difficult to distinguish between similar commodities that are
tax exempt and those that are not, and to distinguish retail sales,
which are taxed, from sales to other companies, which are not taxed.
Similarly, just because a tax is administrable does not necessarily
mean it would be transparent. For example, although payroll taxes are
fairly easy to administer, who pays them in an economic sense is not
necessarily transparent. As we discussed earlier, many economists agree
that employees bear the entire burden (both the employer and employee
share) of payroll taxes, making the incidence of payroll taxes
nontransparent.
Improving the simplicity, transparency, and administrability of the tax
system may affect the equity and efficiency of the tax system.
Simplified, transparent, and administrable tax codes are generally
thought to enhance efficiency because (1) taxpayers can redirect
resources that would have been used to comply with the tax code to
other, more productive purposes and (2) these tax systems have fewer
incentives that distort decision making about work, savings, and
investment. However, proposals to simplify the tax system may reduce
equity because many tax provisions that are complex and difficult to
comply with are also designed to promote fairness.
Key Questions:
1. What impact is the tax proposal likely to have on the compliance
burden that taxpayers face?
* Will more or fewer taxpayers be required to fill out tax forms and
file them with IRS?
* What information will taxpayers be required to provide on the tax
forms?
* Does the proposal contain any estimates of its effect on compliance
burden?
2. Will taxpayers' planning responsibilities (record keeping, research,
etc.) likely increase or decrease in comparison to those under the
current tax system?
3. Is the proposed tax system transparent?
* Can taxpayers identify their tax liability easily?
* Can taxpayers understand the logic behind the tax that they are
paying?
* Do taxpayers know what their true tax burden is (i.e., do they
understand the incidence of the tax system)?
* Do taxpayers understand the incidence of the tax system in terms of
the tax burdens of other taxpayers?
* Are taxpayers aware of the extent of compliance by others?
4. How would the tax system be administered?
* What would be the role of taxpayers, employers, information return
providers, and the IRS under the proposal?
* Does the proposal contain estimates of its effect on budgetary costs?
* Does the proposal contain any information about how administrative
costs would be shared?
5. What would be the proposal's impact on IRS?
* How would IRS functions of processing, compliance, collections, and
taxpayer assistance be affected?
* What enforcement tools (e.g., withholding and information reporting)
would be added or taken away from tax administrators?
* Does the proposal contain information about its likely effect on
compliance?
6. Are there trade-offs between the simplicity, transparency, and
administrability of the proposed tax system?
7. Under the tax proposal, have efforts to enhance the simplicity,
transparency, and administrability of the tax system resulted in trade-
offs with respect to the equity and efficiency of the proposal?
[End of section]
Section 3 Transitioning to a Different Tax System:
[End of section]
Transition rules are sometimes proposed when switching to an
alternative tax system. The rules are often intended to compensate
certain people or entities whose losses are determined to be
inequitable. However, not all tax experts agree that transition rules
are appropriate when implementing changes to the tax code. Since
transition rules are short-term tax policies, they should be judged by
the same criteria for a good tax system that we discussed earlier. Many
of the same trade-offs between the criteria that exist when considering
tax reform proposals are also relevant when considering how to move
from the current tax system to an alternative tax system. (See fig. 16.)
Figure 16: Transition Issues Overview:
[See PDF for image]
[End of figure]
Deciding if Transition Relief Is Necessary:
Changes to the tax code can create winners and losers. Taxpayers'
losses, which are more often discussed in debates than gains resulting
from tax policy changes, may be more obvious when tax changes increase
government revenues or if the changes are designed to be revenue
neutral. However, even tax decreases can create losers depending on
whether the tax burden is redistributed, spending cuts are made, or the
tax burden on future generations is increased. Deciding if transition
relief is necessary involves how to trade off between equity,
efficiency, simplicity, transparency, and administrability.
Decisions about whether to tax previously accumulated savings when
switching to a consumption tax provide an example of the trade-offs
that need to be considered when determining if transition relief is
merited. Some argue that switching from the current tax system to a
consumption tax would merit some transition relief for equity reasons
because accumulated savings, which may have already been taxed once
under the income tax system, would be subject to a second tax when used
for consumption purposes. In other words, those who had saved
previously would be taxed higher than those just beginning to save.
Proponents for transition relief argue that taxpayers who accumulated
savings have an implicit contract with the government that savings
would not be taxed when withdrawn. The notion that taxpayers rely on
the continued existence of government policy when they make economic
decisions is one of the key equity justifications for offering
transition relief.
However, not everyone agrees that transition relief is justifiable
based on equity grounds. Opponents of transition relief argue that
taxpayers knowingly accept the risk that government policy may change
when they make decisions, such as how much to save, and therefore do
not need to be compensated for any losses that result from switching to
an alternative tax system.
There are also trade-offs between equity and efficiency that should be
considered when thinking about transition relief. The efficiency gains
that could be realized by switching to a consumption tax could be
negated if the government offered transition relief to taxpayers.
Taxing accumulated savings is economically efficient because doing so
does not distort work or savings behavior--taxpayers cannot avoid
paying the tax by changing their behavior to work or save less.
Offering transition relief would reduce the revenue gain from taxing
accumulated savings, thereby requiring higher consumption tax rates.
Finally, developing and implementing transition rules could add a
significant amount of complexity to the tax system--a characteristic of
the tax system that the switch to an alternative tax system was likely
intended to reduce. The new complexity would be temporary, phasing out
with the transition rules.
Identifying Affected Parties:
Identifying winners and losers, the amount of gains and losses, and
effective mitigation policies is complicated by the different ways tax
changes can affect taxpayers. Tax law changes, by definition, affect
taxpayers' future liabilities. In some cases, those future tax changes
are capitalized into the prices of marketable assets. For example,
changes in the tax treatment of owner-occupied housing have the
potential to affect current housing prices. In other cases, such as
wealth accumulated in a savings account, tax law changes might affect
the value of the wealth but do not change the price of a marketable
asset. In still other cases, the after-tax return to future behavior,
such as hours worked, is altered. Regardless of how taxpayers feel the
impact of a tax change, the impact on their ability to consume over
time is the same (assuming everything else is constant).
Revenue Effects of Transition Relief:
If transition relief is provided to compensate taxpayers for financial
losses due to changes in the tax code, then revenues equivalent to
these losses will need to be found from other sources, assuming the
proposal is revenue neutral. One alternative source of revenue would be
to tax those who have received windfall gains from the policy changes.
However, debates about transition relief typically center around how to
handle taxpayers who are likely to suffer windfall losses and not on
how to impose special taxes on those who experience windfall gains.
Policy Tools for Implementing Transition Rules:
The two most commonly discussed policy tools for transitioning to an
alternative tax system are grandfather clauses and phase-in rules.
* Grandfather clauses: Grandfather clauses are typically used to exempt
people who would be subject to a new rule from the provisions of that
rule. Grandfather clauses are generally used to exempt current assets
or investments from new tax rules in order to protect taxpayers who
purchased those assets from being penalized by unexpected changes to
the tax system. One problem with grandfather clauses is that over time
they can lead to unequal tax treatment of similar assets.
* Phase-in periods for new laws: Another form of transition relief
would be to phase in new legislation over a period of time in order to
reduce the effects that new tax laws would have on taxpayers.
* Combination of grandfather clauses and phase-in periods: It would
also be possible to develop transition rules that allow for certain
assets/investments to be grandfathered and others subject to phased-in
tax laws. One possible variant previously outlined by the Treasury
Department would be to apply new tax laws immediately to all new assets
but phase in the tax laws on existing assets.
Key Questions:
1. Does the proposal include transition rules?
* If so, what are they?
* What gains and losses are the rules intended to mitigate?
* Who bears these gains or losses?
2. What are the expected revenue effects of the transition rules?
* If the proposal is intended to be revenue neutral, what additional
revenue sources will be used during the transition period?
3. How will the transition rules affect the equity of the tax system as
a whole?
* Why were some taxpayers selected for transition relief but not others?
* Who will pay for the transition relief?
4. How will the transition rules affect the overall efficiency of the
tax system?
* Do the transition rules have efficiency costs that offset some of the
gains from changing the tax system?
* Do estimates of these efficiency costs exist?
5. How will the transition rules affect the overall simplicity,
transparency, and administrability of the tax system?
[End of section]
Appendixes:
Appendix I: Key Questions:
Section I: Revenue Needs--Taxes Exist to Fund Government:
1. What current taxes would the proposal change?
* Does the proposal change personal income taxes, social insurance
taxes, corporate income taxes, and/or estate and gift taxes?
2. What is the nature of the proposed change to the tax system?
* Does the proposal change the tax base from income to consumption?
* Does the proposal include tax expenditures?
* Does the proposal change the tax rates?
* Does the proposal change the collection points for the tax?
3. How will the proposed change affect total revenues?
* Are proposed changes to the tax code likely to be revenue neutral?
* If not, will they generate more or less revenue than the current tax
laws?
4. What effect would the proposal have on the nation's projected
budgets and long-term fiscal outlook?
* Does the proposal take into consideration the sizable long-term
fiscal gap that the country faces?
5. What tax expenditures are included in the proposal, and what tax
expenditures, if any, have been removed from the current tax system?
* Are the social and economic goals of the tax expenditures likely to
be achieved and worth the cost in lost revenue?
* When the total costs of a program are considered, would it be less
costly to implement the program as a tax expenditure or as a spending
program?
6. If the proposal changes the tax base, the tax rates, or the
collection points, how would these changes alter the amount of revenue
that the government is able to collect?
7. What implications, if any, would the proposal have on the ability of
state and local governments to collect tax revenues?
* Would the proposal tax the same base that many states rely on?
* Would the proposal allow many states to continue to rely on the
federal tax base as a starting point for determining state taxes?
Section II: Criteria for a Good Tax System:
Equity:
1. How is a taxpayer's ability to pay broadly defined:
* Income?
* Consumption?
* A broader definition of overall wealth?
2. What factors other than income, such as medical expenses, number of
dependents, and so forth, does the proposal account for when
considering a taxpayer's ability to pay taxes?
3. Will taxpayers with equal ability to pay taxes pay the same amount?
* If not, what provisions of the proposal do not adhere to the
principle of horizontal equity?
4. How will the tax system tax people with differing ability to pay?
* Are the statutory tax rates progressive, proportional, or regressive?
* Are the average effective tax rates progressive, proportional, or
regressive (accounting for credits, deductions, and other tax
expenditures)?
5. Are there any components of the tax proposal that are justified on
the benefits received principle?
* If so, what mechanisms are in place to determine that taxpayers who
pay taxes for a particular government program are the same taxpayers
who benefit from the provisions of that program?
6. Does the proposal change the distribution of taxes (i.e., is the
proposal distributionally neutral)?
* If not, who will be paying more in taxes and who will be paying less?
* If so, what features of the proposal are in place to ensure that it
will remain distributionally neutral?
7. What type of distributional analysis was done?
* What time period is covered? For example does the distributional
analysis measure the lifetime or annual effects of the tax system?
* How is ability to pay (income, consumption, or wealth) measured?
* What is the unit of analysis (individuals, households, or taxpaying
units, etc.)?
* What assumptions are made about tax incidence (e.g., who is assumed
to pay the corporate income tax)?
* What taxes are covered in the distributional analyses?
* What measures (e.g., tax rates, share of tax liability) are being
used to calculate the distribution of tax burden?
Efficiency:
1. Does the proposal tax income, spending, assets, and investments
differentially?
* Which types of income, spending, assets, and investments are tax
preferred?
* Which decisions are likely to be distorted?
2. What social goals, if any, is the tax proposal trying to promote?
* Is there an efficiency justification for the goal, or is the goal
justified on other grounds, such as equity?
3. Do estimates of the cost of achieving the goal include efficiency
costs?
4. What are the trade-offs between equity, efficiency, and the other
criteria?
5. Is the tax proposal accompanied by estimates of the efficiency gains
or losses to be realized by the new tax system?
* Is the tax proposal accompanied by estimates of economic activity
(e.g., change in labor supply or change in gross domestic product
(GDP)) that will be encouraged or discouraged by the new tax system?
* Is the proposal accompanied by estimates of the efficiency loss or
gain associated with these changes in economic activity?
6. How does the tax change affect leisure versus work decisions?
7. How does the tax change affect savings versus consumption decisions?
8. How does the tax system affect decisions about foreign versus
domestic investment?
9. How does the tax change affect choices between different types of
investments and different types of consumption?
10. Is the tax proposal likely to increase economic growth?
* Is the growth achieved through a onetime rearranging of resources?
* Is the growth achieved through a permanent increase in the rate of
growth?
* Does the tax proposal contain estimates of its effect on growth
(often measured by changes in GDP) and estimates of the costs of
achieving the growth (such as reduced leisure time)?
11. In addition to efficiency effects, will the proposal have other
economic effects by increasing or reducing the deficit?
Simplicity, Transparency, and Administrability:
1. What impact is the tax proposal likely to have on the compliance
burden that taxpayers face?
* Will more or fewer taxpayers be required to fill out tax forms and
file them with the Internal Revenue Service (IRS)?
* What information will taxpayers be required to provide on the tax
forms?
* Does the proposal contain any estimates of its effect on compliance
burden?
2. Will taxpayers' planning responsibilities (record keeping, research,
etc.) likely increase or decrease in comparison to those under the
current tax system?
3. Is the proposed tax system transparent?
* Can taxpayers identify their tax liability easily?
* Can taxpayers understand the logic behind the tax that they are
paying?
* Do taxpayers know what their true tax burden is (i.e., do they
understand the incidence of the tax system)?
* Do taxpayers understand the incidence of the tax system in terms of
the tax burdens of other taxpayers?
* Are taxpayers aware of the extent of compliance by others?
4. How would the tax system be administered?
* What would be the role of taxpayers, employers, information return
providers, and the IRS under the proposal?
* Does the proposal contain estimates of its effect on budgetary costs?
* Does the proposal contain any information about how administrative
costs would be shared?
5. What would be the proposal's impact on IRS?
* How would IRS functions of processing, compliance, collections, and
taxpayer assistance be affected?
* What enforcement tools (e.g., withholding and information reporting)
would be added or taken away from tax administrators?
* Does the proposal contain information about its likely effect on
compliance?
6. Are there trade-offs between the simplicity, transparency, and
administrability of the proposed tax system?
7. Under the tax proposal, have efforts to enhance the simplicity,
transparency, and administrability of the tax system resulted in trade-
offs with respect to the equity and efficiency of the proposal?
Section III: Transitioning to a Different Tax System:
1. Does the proposal include transition rules?
* If so, what are they?
* What gains and losses are the rules intended to mitigate?
* Who bears these gains or losses?
2. What are the expected revenue effects of the transition rules?
* If the proposal is intended to be revenue neutral, what additional
revenue sources will be used during the transition period?
3. How will the transition rules affect the equity of the tax system as
a whole?
* Why were some taxpayers selected for transition relief but not others?
* Who will pay for the transition relief?
4. How will the transition rules affect the overall efficiency of the
tax system?
* Do the transition rules have efficiency costs that offset some of the
gains from changing the tax system?
* Do estimates of these efficiency costs exist?
5. How will the transition rules affect the overall simplicity,
transparency, and administrability of the tax system?
[End of section]
Appendix II: Selected Bibliography and Related Reports:
Government Accountability Office:
Government Performance and Accountability: Tax Expenditures Represent a
Substantial Federal Commitment and Need to Be Reexamined. [Hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-690] (Forthcoming).
Tax Policy: Summary of Estimates of the Costs of the Federal Tax
System.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-878]
(Forthcoming).
Tax Compliance: Reducing the Tax Gap Can Contribute to Fiscal
Sustainability but Will Require a Variety of Strategies.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-527T] Washington,
D.C.: April 14, 2005.
21ST Century Challenges: Reexamining the Base of the Federal
Government.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-325SP] Washington,
D.C.: February 1, 2005.
Federal Debt: Answers to Frequently Asked Questions--An Update.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-485SP] Washington,
D.C.: August 12, 2004.
The Honorable David M. Walker, Comptroller General of the United
States. Truth and Transparency: The Federal Government's Financial
Condition and Fiscal Outlook. Address to the National Press Club.
September 17, 2003.
Alternative Minimum Tax: An Overview of Its Rationale and Impact on
Individual Taxpayers.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-180]
Washington, D.C.: August 15, 2000.
Tax Administration: Potential Impact of Alternative Taxes on Taxpayers
and Administrators.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-37]
Washington, D.C.: January 14, 1998.
Congressional Budget Office:
Statement of Douglas Holtz-Eakin, Director. The Economic Costs of Long-
Term Federal Obligations. Washington, D.C.: February 16, 2005.
Effective Tax Rates: Comparing Annual and Multiyear Measures.
Washington, D.C.: January 2005.
Effective Federal Tax Rates Under Current Law, 2001 to 2014.
Washington, D.C.: August 2004.
Revenue and Tax Policy Brief: The Alternative Minimum Tax, No. 4.
Washington, D.C.: April 15, 2004.
Effective Federal Tax Rates, 1997 to 2000. Washington, D.C.: August
2003.
Options to Cut Taxes. Washington, D.C.: June 2000.
The Incidence of the Corporate Income Tax. Washington, D.C.: March
1996.
Library of Congress, Congressional Research Service:
Esenwein, Gregg A. and Jane G. Gravelle. The Flat Tax, Value-Added Tax,
and National Retail Sales Tax: Overview of the Issues. CRS Report
RL32603. Washington, D.C.: December 14, 2004.
Esenwein, Gregg A. The Alternative Minimum Tax for Individuals. CRS
Report RL30149. Washington, D.C.: November 15, 2004.
Labonte, Marc. The Size and Role of Government: Economic Issues. CRS
Report RL32162. Washington, D.C.: March 22, 2005.
Luckey, John R. Federal Estate, Gift, and Generation-Skipping Taxes: A
Description of Current Law. CRS Report 95-416. Washington, D.C.:
January 5, 2005.
Other Selected Sources:
Aaron, Henry J. and William G. Gale. Economic Effects of Fundamental
Tax Reform. Washington, D.C.: Brookings Institution Press, 1996.
Cai, Jinyong and Jagadeesh Gokhale. "The Welfare Loss From a Capital
Income Tax." Federal Reserve Bank of Cleveland Economic Review, vol.
33, no. 1 (1997).
Cronin, Julie-Anne. U.S. Treasury Distributional Analysis Methodology,
Office of Tax Analysis Paper 85. Washington, D.C.: U.S. Department of
the Treasury, September 1999.
Feldstein, Martin, "Tax Avoidance and the Deadweight Loss of the Income
Tax." The Review of Economics and Statistics, vol. 81, no. 4 (1999):
674-680.
Gravelle, Jane G., "The Corporate Tax: Where Has It Been and Where Is
It Going?" National Tax Journal, vol. 57, no. 4 (2004): 903-23.
Joint Committee on Taxation, Methodology and Issues in Measuring
Changes in the Distribution of Tax Burdens. JCT Report JCS-7-93.
Washington, D.C.: June 1993.
Mikesell, John L. Fiscal Administration: Analysis and Application for
the Public Sector, 5TH Edition. Fort Worth, Tex.: Harcourt Brace
Publishers, 1999.
[End of section]
Appendix III: Glossary:
Ability to Pay Principle; A concept of tax fairness that states that
people with different amounts of wealth, income, or other levels of
well-being should pay tax at different rates. Wealth includes assets
such as houses, cars, stocks, bonds, and savings accounts. Income
includes wages, interest, dividends, and other payments.
Adjusted Gross Income (AGI); All income subject to taxation under the
individual income tax after subtracting certain deductions, such as
certain contributions for individual retirement accounts, and alimony
payments. Personal exemptions and the standard or itemized deductions
are also subtracted from AGI to determine taxable income.
Alternative Minimum Tax (AMT); A separate tax system that applies to
both individual and corporate taxpayers. It parallels the income tax
system but with different rules for determining taxable income,
different tax rates for computing tax liability, and different rules
for allowing the use of tax credits.
Average Tax Rates; The total amount of tax a taxpayer pays divided by
some measure of his or her income. In the current tax system, average
tax rates are sometimes presented as the amount of tax a taxpayer pays
divided by his or her taxable income. Average effective tax rates
differ in that they are developed using a broader measure of total
income than taxable income.
Benefits Received Principle; A concept of tax fairness that states that
people should pay taxes in proportion to the benefits they receive from
government goods and services.
Capital Gains; A capital asset's selling price less its initial
purchase price. Investments that have been sold at a profit are called
realized capital gains. Investments that have not yet been sold, but
would yield a profit if they were sold have unrealized capital gains.
Collection Point; The individual or business that actually remits
payment of taxes to the government.
Compliance Burden; The time and resources, including out-of-pocket
costs, that taxpayers spend each year in order to comply with the tax
laws. Compliance burden is often cited as a measure of the overall
simplicity of the tax code.
Consumption Tax Base; A tax base where people pay taxes on goods and
services that they purchase, or consume, effectively excluding savings
and investment from the tax base. Capital assets are usually fully
expensed when purchased under a consumption tax rather than depreciated
over time, as is the case under an income tax.
Corporate Income Taxes; Taxes paid by corporations on net income, or
the difference between corporate revenues and corporate business
expenses.
Credit; An amount that offsets or reduces tax liability. When the
allowable credit amount exceeds the tax liability, and the difference
is paid to the taxpayer, the credit is considered refundable.
Deduction; An amount that is subtracted from the tax base before tax
liability is calculated. Deductions claimed before and after the
adjusted gross income line on the Form 1040 are sometimes called "above
the line" and "below the line" deductions, respectively.
Deficit; The amount by which the government's spending exceeds its
revenues for a given period, usually a fiscal year.
Defined Contribution Pension Plans; A type of retirement plan that
establishes individual accounts for employees to which the employer,
participants, or both make periodic contributions. Employees bear the
investment risk and often control, at least in part, how their
individual account assets are invested.
Discretionary Spending; Outlays controlled by appropriation acts, other
than those that fund mandatory programs.
Distortion; Changes in behavior, such as how much to work, what to
consume, and where to invest, due to taxes, government benefits, or
monopolies.
Distributional Analysis; An analytical tool used by government agencies
and other analysts to identify how different tax proposals or tax
systems would affect different groups of taxpayers with differing
ability to pay taxes, usually measured by income.
Dividend Income; A taxable payment made by a company to its
shareholders, often quarterly, out of the company's retained earnings.
Dividends are usually given out in the form of cash, but can also be
given out as stock or other property.
Economic Incidence; The person or group of people that actually bear
the burden of a tax regardless of who remits payment to the government.
For example, even though businesses remit tax sales tax payments to the
government, individuals who purchase items may bear the actual burden
of the tax.
Effective Tax Rates; The amount of tax that a taxpayer pays to the
government expressed as a percentage of some overall measure of total
income.
Efficiency Costs; A reduction in economic well-being caused by
distortions, or changes in behavior due to taxes, government benefits,
monopolies, and other forces that interfere in the market. Efficiency
costs can take the form of lost output or consumption opportunities.
Employer-Provided Health Care; Insurance plans offered by employers to
employees where the employer pays all or a portion of an employee's
health insurance costs. Employer-provided health care payments are not
counted as nonwage income, and therefore these payments are not subject
to taxation.
Entitlement; Programs that require the payment of benefits to persons,
state or local governments, or other entities if specific criteria
established in the authorizing law are met.
Estate and Gift Taxes; Assets an individual owns at the time of his or
her death or gifts made during the course of his or her life may be
subject to transfer taxes, sometimes referred to as estate and gift
taxes. Estate and gift taxes are more likely to affect wealthier
individuals, and most citizens are unaffected by estate and gift taxes.
Excise Taxes; A tax on the sale or use of specific products or
transactions.
Exemption; A part of a person's income on which no tax is imposed. It
is the amount that taxpayers can claim for themselves, their spouses,
and eligible dependents. There are two types of exemptions--personal
and dependency. Each exemption reduces the income subject to tax. The
exemption amount is a set amount that changes from year to year.
Externality; A benefit or cost that is not captured or paid by the
individuals or firms creating them.
Flat Tax; A type of tax reform proposal that, in most cases would
change the tax base to a consumption tax base and impose a single, or
flat, tax rate on individuals and businesses. Most flat tax proposals
would not really be "flat" because they grant exemptions for at least
some earnings.
Grandfather Clause; Provisions that are typically used to exempt people
who would be subject to a new rule from the provisions of that rule.
Thus, in the case of tax law changes, only people who engage in certain
activities after a tax law change will be affected by changes to the
tax treatment of that activity.
Gross Domestic Product (GDP); The value of all final goods and services
produced within the borders of a country such as the United States
during a given period. The components of GDP are consumption
expenditures (both personal and government), gross investment (both
private and government) and net exports.
Horizontal Equity; The concept that people with the same ability to pay
should be taxed at the same rate.
Income Tax Base; A tax base where individuals are taxed on the basis of
income, or both the goods and services they consume as well as their
savings and investments. Under an income tax, capital assets are
usually depreciated over time rather than being fully expensed at the
time they are purchased, as would be the case under a consumption tax.
Individual Retirement Accounts; Investment accounts that allow people
to save a certain amount of income each year and, in most cases, deduct
the savings from taxable income, with the savings and interest tax
deferred until the person retires.
Mandatory Spending; Also known as "direct spending." Mandatory spending
includes outlays for entitlements (for example, food stamps, Medicare,
and veterans' pension programs), interest payments on the public debt
and nonentitlements such as payments to the states from Forest Service
receipts. By defining eligibility and setting the benefit or payment
rules, the Congress controls spending for these programs indirectly
rather than through appropriations acts.
Marginal Tax Rates; Tax rate that taxpayers pay on the next dollar of
income that is earned. Marginal tax rates can be presented as both
marginal statutory rates and marginal effective rates.
Medicaid; A federal program that states administer to help pay medical
costs for low income citizens. Each state in which applicants for the
program reside establishes criteria for financial need. Medicaid
supplements Medicare to pay for some of the costs that Medicare does
not cover.
Medicare; A federal entitlement program that delivers medical care to
eligible workers, spouses of workers, and retired workers when they
reach age 65.
Net Tax Gap; The difference between taxes legally owed to the
government and taxes actually paid to the government, less collected
enforcement revenue.
Payroll Taxes; Often synonymous with social insurance taxes. However,
in some cases the term "payroll taxes" may be used more generally to
include all tax withholding. For the purposes of this report, payroll
taxes are synonymous with social insurance taxes.
Personal Income Taxes; Taxes on income earned by individuals, including
income from wages, interest, and nonwage income.
Phase-in Rule; A rule that allows for a new tax provision to be
implemented gradually rather than immediately upon enactment of a new
tax law. Phase-in rules help mitigate windfall losses during the
transition to a new set of tax laws.
Progressive Tax Rates; A tax rate structure where tax liability as a
percentage of income increases as income increases.
Proportional Tax Rates; A tax rate structure where taxpayers pay the
same percentage of income, regardless of their income.
Regressive Tax Rates; A tax rate structure where tax liability is a
smaller percentage of a taxpayer's income as income increases.
Retail Sales Tax; A tax levied on the sale price of a good and
collected by the seller of the good.
Revenue Neutral; A term applied to tax bills or proposals are designed
to raise the same amount of revenue as the system that is being
replaced.
Social Insurance Taxes; Tax payments to the federal government for
Social Security, Medicare, and unemployment compensation. While
employees and employers pay equal amounts in social insurance taxes,
economists generally agree that employees bear the entire burden of
social insurance taxes in the form of reduced wages.
Spillovers; See externality.
Standard Deduction; A deduction that reduces income subject to tax and
varies depending on filing status, age, blindness, and dependency. The
standard deduction is taken instead of itemizing deductions.
Statutory Incidence; The party, usually an individual or a business,
that is legally required to pay a tax to the government.
Statutory Tax Rate; Tax rates as written into law.
Tax Burden; See economic incidence.
Tax-Exempt Bonds; Bonds issued by state and local governments for
public projects on which interest that is earned is exempt from federal
income tax.
Tax Expenditures; A revenue loss attributable to a provision of the
federal tax laws that grants special tax relief that encourages certain
kinds of behavior by taxpayers or to aid taxpayers in special
circumstances. The Congressional Budget and Impoundment Act of 1974
lists six types of tax expenditures: exclusions, exemptions,
deductions, credits, preferential tax rates, and deferrals.
Tax Incidence; See economic incidence.
Tax Liability; The amount of tax that a taxpayer is legally required to
pay to the government at a given time.
Tax Preferences; See tax expenditures.
Taxable Income; Income subject to tax that is used to determine tax
liability. In the case of the federal income tax, taxable income is
equal to a taxpayer's adjusted gross income less personal deductions
and exemptions.
Third-Party Information Reporting; Information reported to IRS by third
parties, such as banks or employers, that allows IRS to verify that
information reported by taxpayers on their tax returns is accurate.
Value-Added Tax; A tax levied at each stage of production or
distribution on the value added to the product during that stage of
production. Value-added taxes are now commonly used in many Western
European countries as a source of revenue.
Vertical Equity; The concept that people with differing ability to pay
taxes should pay different rates of taxes or different percentages of
their incomes in taxes.
Voluntary Compliance; A system of compliance that relies on individual
citizens to report their income freely and voluntarily, calculate their
tax liability correctly, and file a tax return on time.
Windfall Gain; A sudden and usually unexpected gain for a taxpayer or
group of taxpayers owing to changes to the tax system.
Windfall Loss; A sudden and usually unexpected loss for a taxpayer or
group of taxpayers owing to a change in the tax system. Transition
rules are often proposed to mitigate the effects of windfall losses.
[End of section]
FOOTNOTES
[1] Summing outlay equivalent estimates is controversial because doing
so does not take into account possible interactions among tax
expenditures. In addition, there are several ways to define and measure
tax expenditures. The size of a tax preference can change over time.
For example, accelerated depreciation of machinery and equipment drops
out of the list of the top 10 tax expenditures in 2006. Moreover, what
is considered a tax expenditure depends on the tax base. Some
provisions of the tax code that are considered tax expenditures under
an income tax base would not be considered tax expenditures under a
consumption tax base. For further information on how tax expenditures
are defined and measured, see GAO, Government Performance and
Accountability: Tax Expenditures Represent a Substantial Federal
Commitment and Need to Be Reexamined, GAO-05-690 (forthcoming).
[2] GAO, 21ST Century Challenges: Reexamining the Base of the Federal
Government, GAO-05-325SP (Washington, D.C.: February 2005).
[3] Martin Feldstein, "Tax Avoidance and the Deadweight Loss of the
Income Tax," The Review of Economics and Statistics, vol. 81, no. 4
(1999).
[4] Jinyong Cai and Jagadeesh Gokhale, "The Welfare Loss From a Capital
Income Tax," Federal Reserve Bank of Cleveland Economic Review, vol.
33, no. 1 (1997).
[5] It is difficult to measure the amount of time that taxpayers spend
planning and preparing their returns because, among other reasons, when
surveyed, taxpayers may overstate or understate the amount of time that
they spent depending on how straightforward or complicated their
returns were (i.e., how frustrating the experience was). Additionally,
there is no consensus among researchers regarding the appropriate
monetary value to be assigned to each hour of time spent on tax
compliance activities.
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